In the April 2011 issue of Accounting Insights, we provided an update on the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) (collectively "the Boards") exposure draft, Leases, which was originally released in August 2010. This update included various changes to the proposed standards covering accounting for leases, including clarification on lease terms, variable lease payments, short-term leases, and sale-leaseback transactions.
In May 2013, the Boards released revised exposure drafts for the proposal of new lease accounting guidance. The Boards’ revised proposals are very similar in nature and represent significant progress in the international convergence project to create more unified financial reporting for leases. The new proposals include significant changes to lease accounting from FASB’s 2010 lease proposal.
If the 2013 proposal is adopted in final form, the guidance will require balance sheet recognition of many previously unrecognized leased assets and liabilities, as well as significant other changes to current accounting principles generally accepted in the United States (US GAAP). The new guidance is applicable to public companies, private companies, and not-for-profit entities. At this time, the Boards have not set effective dates for the proposed guidance, as they anticipate significant feedback given the extent of the changes and the number of affected entities.
The exposure drafts address accounting for lease arrangements in the financial statements of lessors and lessees. The most significant change in the new proposals calls for a dual-recognition approach to the recognition, measurement, and presentation of expenses and cash flows derived from leasing arrangements, which is summarized below. Additionally, the proposed guidance requires the lessee to recognize a liability for future lease payments and a right-of-use asset for leases with a term of more than twelve months.
Under the dual-recognition approach, the accounting by lessees and lessors will depend on whether the lessee will consume a more than insignificant portion of the leased asset. Short-term leases, defined as leases with a maximum possible lease term of twelve months or less, including renewal options, may be excluded from the proposed exposure draft, and may continue to be accounted for similar to an operating lease.
Type A lease:
Most leases of assets other than property, in which a more than insignificant portion of the asset will be consumed (i.e., equipment, aircraft, cars and trucks).
Lessee: A lessee will record the lease as a right-of-use asset and a corresponding lease liability, both initially measured at the present value of the future lease payments. The lessee will then report the amortization of the leased asset separately from interest expense on the related lease liability.
Lessor: A lessor will derecognize the underlying asset and recognize a receivable for future lease payments as well as a residual asset, which represents the rights the lessor retains relating to the underlying asset. The unwinding of the discount on both the lease receivable and the residual asset will be recognized as interest income over the lease term, and any profit relating to the lease will be recognized at the commencement date.
Type B lease:
Most leases of property, in which a more than insignificant portion of the asset will not be consumed (i.e., land and/or a building or part of a building).
Lessee: A lessee will recognize a right-of-use asset and lease liability, at the same amount as with Type A. The lessee will then recognize a single lease cost on the income statement consisting of the unwinding of the discount on the lease liability with the amortization of the right-of-use-asset on a straight-line basis.
Lessor: A lessor will continue to recognize the underlying asset and will recognize rental income over the lease term on a straight-line basis.
The proposed guidance using the dual-recognition approach may affect different industries with varying levels of severity depending on the nature and extent of leasing arrangements. One major effect will be the increased need for professional judgment surrounding the determination of more than insignificant. The Boards have included interpretations, including examples and guidance on implementation of this concept. In the examples, it is evident that the determination shall not be made based on the type of leased asset or industry, but all facts and circumstances surrounding the terms of the lease should be considered in identifying the appropriate accounting.
For example, consider a 25-year lease term on a building that has been assigned a 40-year useful economic life. Under current US GAAP, such a lease would be subject to bright-line rules to determine the accounting for the lease. Under the proposed guidance, such rules will be eliminated from accounting literature, and the lease would be subject to an evaluation as to whether the use of the asset during the term of the lease will consume more than an insignificant portion of the asset. This requires the evaluation of the circumstances surrounding the nature and intended use of the leased asset and the consumption of the asset over time. Alternatively, a similar asset with a much shorter lease term, such as three years, may be more clearly evaluated for these criteria.
Aside from the extensive accounting and financial reporting implications for both current and future leases, there are myriad practical and business implications that entities should begin evaluating to ensure an orderly transition and prevent costly oversights. The proposed guidance may have significant implications on business plans and overall strategies, buy vs. lease decisions, financing arrangements and covenant calculations, contract negotiations, and virtually any other area that is affected by financial condition or results of operations. Evaluation and implementation will require a cross-functional effort. While an effective date for the proposed standard has not been set, entities should utilize the time between the exposure draft and the effective date of a final standard to begin a preliminary assessment of the effects and necessary changes across their organizations.
The new proposals aim to increase the global comparability of financial reporting over leases. The Boards’ revised exposure drafts are open for comments through September 13, 2013.