Leasing of equipment, real estate, and other assets has been and continues to be a significant source of financing for businesses in all industries. As a result, the financial reporting rules for the treatment of lease transactions can be significant to the financial statements and the business operations of lessees and lessors alike.
The financial reporting standards in the United States currently provide that all lease transactions will be accounted for in one of two ways depending on facts, circumstances, and to some degree the judgment of the users. The two alternative treatments, referred to as operating leases and capital leases, have dramatically different consequences on the financial statements of both lessees and lessors. There are a number of perceived weaknesses in these rules and the manner in which they are applied, which many believe result in inconsistent and incomplete reporting and presentation of an entity’s leasing activities. In response, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have undertaken a joint project on leases to improve the financial reporting for lease transactions.
In March of 2009, the FASB and the IASB issued a discussion paper outlining proposed changes to the lease accounting standards. After receiving feedback from a wide range of constituents, the FASB issued an exposure draft (ED) on August 17, 2010 that includes a proposed accounting framework that will significantly change the accounting for leases in the United States. Highlights of the ED and its impact include:
- The proposed changes are significant and will impact the financial reporting for both lessees and lessors in substantially all lease transactions.
- Classification of lease transactions as operating leases will cease, thus eliminating the off-balance sheet treatment of the obligations under a lease agreement.
- Lessees and lessors may have to alter existing or adopt new policies, processes, and procedures to address the changes, and will be required to continually evaluate judgments and estimates used under the proposed framework over the life of the lease.
- Existing leases and new leases will be affected – that is, existing lease transactions will not be afforded grandfathered treatment.
Why the change?
Since the issuance of the existing financial reporting standard in the late 1970’s, standard setters and other interested parties have long debated how to improve lease accounting for users. Existing lease accounting standards require lessees to classify their lease contracts as either capital leases or operating leases. Capital leases are defined as those leases that transfer to the lessee substantially all the risks and rewards incidental to ownership of the leased asset. All other leases are operating leases.
Existing accounting model for lessees / tenants
Leases classified as capital leases are treated similar to a purchase of the underlying asset. The lessee recognizes the leased item in its balance sheet and an obligation to pay rentals. The lessee depreciates the leased item and apportions lease payments between interest expense and a reduction of the outstanding liability. No similar assets or liabilities are recognized by the lessee when the lease is classified as an operating lease. The lessee recognizes lease payments under an operating lease as an expense normally on a straight-line basis over the lease term.
Existing accounting model for lessors / landlords
If a lease is classified as a capital lease, the lessor derecognizes the leased asset and recognizes a receivable for an amount equal to the net investment in the lease (present value of the minimum lease payments and present value of any unguaranteed residual value). If the lease is classified as an operating lease, the lessor continues to recognize the leased asset and income is normally recognized on a straight line basis over the lease term.
Criticisms of the existing accounting model
The existing model has been criticized for failing to provide the appropriate and comparable information to users of the financial statements. Many users have long viewed lease transactions as binding obligations that should be reflected as such in the financial statements just as is any other obligation. In addition, the criteria used to determine if a lease transaction is capital versus operating are somewhat arbitrary and represent “bright-line" tests. As a result, seemingly similar transactions may be afforded substantially different treatment in financial statements. This has resulted in the lack of comparability in some cases, impairing a financial statement user’s ability to make the most informed decisions based upon those financial statements. These bright-line tests have also precipitated manipulation of transaction terms in order to achieve the desired financial reporting outcome, which may serve to decrease the usefulness of the information reported in the financial statements. While the existing financial reporting rules require robust disclosure related to all lease transactions, users have indicated that these disclosures may be insufficient to facilitate clear reporting and comparability of financial position and results of operations amongst companies.