Proposed changes in lease accounting
In August 2010, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) jointly issued a new exposure draft (“ED”) on accounting for leases. This ED is set to change the way companies will account for leases and could potentially have a significant impact to your business. This summary is meant to illustrate some of the impacts if the ED is adopted as currently drafted. The summary is not intended to address every scenario or exception that could be allowed for. We will continue to monitor the progress of the ED and update you as appropriate however, given the significance of the potential changes and the widespread use of leases we wanted to provide this information as timely as possible.
In order to identify how these proposed new lease accounting rules could affect your business, we first need to outline the current lease accounting rules under Accounting Standards Code (ASC) 840 “Accounting for Leases” and IAS 17 “Leases.”
Currently for lessees, operating leases have a minimal impact to the balance sheet and impact the statement of income primarily through lease rental expense. Capital leases are currently accounted for by capitalizing the leased asset and setting up a liability for any future lease payments. This creates a capital leased asset and liability on the balance sheet while the statement of income is impacted through depreciation expense and interest expense.
Under current accounting rules, generally lessors record rental revenue associated with operating leases and a corresponding rental receivable or receipt of cash. The lessor holds the asset on their books and depreciates the property using an applicable method over the life of the asset. Under capital lease accounting, lessors record a lease receivable for the present value of the total rents and credits the owned asset. Interest income is also recorded, if applicable.
The new proposed guidance effectively suggests operating leases will be accounted for similarly to capital leases, therefore there will not be a difference between the two for accounting purposes. As such, there will no longer be separate “capital” and “operating” leases. Under the new proposed standard, companies will be required to calculate an “obligation to pay” liability and book an offsetting “right of use” asset. Essentially, the new proposal will gross up a balance sheets as the asset will be reported on both the lessor and lessee’s balance sheet.
Adjusting journal entries related to this change will be a direct result of the calculation of the obligation to pay liability. Essentially, once the liability is determined, the offset will be to increase the asset base.
The liability is calculated using the present value (PV) of the lease payments discounted using the lessee’s incremental borrowing rate or at the rate charged by the lessor. Like many accounting issues there is a fair amount of judgment and assumptions necessary when determining the lease term and other factors within the calculations. Companies will be required to use the “most likely” lease term. This means the expected lease term having greater than a 50% likelihood of being realized. Companies must consider lease renewal options, lease extension clauses and termination dates in their variable inputs. Companies are also required to include the value of contingent rents, termination penalties, and the impact of any residual guaranties in their PV calculation. The PV calculation should not include operating expenses and the amortized costs from the calculated obligation are to be determined using the effective interest method. The calculation also excludes the exercise price of a purchase option within a lease contract.
The offsetting right of use asset is determined as the PV of the lease payments plus any initial direct costs incurred by the lessee. The asset is amortized over a straight-line basis over the “most likely” lease term as defined in the preceding paragraph. Essentially, straight line rent expense is replaced with a high-low expense profile. Companies will face an accelerated expense profile due to the interest expense associated with the PV calculation. Effectively, the new standard takes into consideration the timing and value of the lease commitment.
As the calculated value requires judgment, there are certain assumptions that will require monitoring and periodic updates. At each reporting period, companies are encouraged to review and update their prior estimates used, such as lease terms, more likely than not scenarios, contingent rents, etc. The review is required annually if not performed at each reporting period for publically traded companies. The impact of the adjustments at each reporting period will affect the asset values, obligation to pay and net income. Also, during subsequent periods, the lessee would be required to assess the value of their right of use asset for impairment and adjust accordingly. The assumptions used and the periodic assessments should be documented and reviewed as part of the closing process.
Under the proposed ED, lessor accounting changes stem from the level of risk associated with the leased assets. Lessors would either incorporate the performance obligation method of accounting or the derecognition method of accounting. The choice of method is based on the risk of exposure the lessor faces during and after the lease period.
Lessors are required to recognize the value of the asset and liability related to a lease. If the lessor faces risk of exposure during or after the lease period, or has the ability to recognize profit through re-rental or sale of the property at the end of the lease period, they would be required to apply the performance obligation method of accounting for leases. If the lessor does not face these types of risks and exposures, they would be allowed to apply the derecognition method.
Performance Obligation Approach:
Under the performance obligation approach, lessors would continue to record an asset for the property they are leasing to a third party. They would also recognize a new liability that represents the third party’s right to use the property (a performance obligation). This would be recorded similarly to the lease receivable as the present value of the estimated total lease payments.
At subsequent periods, the lease receivable would be evaluated for impairment based on changes in estimates that may have occurred between reporting periods (renewal periods, termination plans, and other non-performance related factors). The offsetting liability would also need to be impaired due to the change in the estimated future lease payments calculation. If the impairment of the lease receivable and obligation are due from changes to estimates in performance related factors (i.e. estimated amounts under termination options, contingencies, estimated residual value guarantees, etc.), then the lessor must record these changes against income immediately. Losses based on revised estimates are also recorded immediately.
Also under this method, the lease receivable would be recorded at amortized cost on the balance sheet. The initial performance obligation liability would subsequently be amortized based on the amount of use by the lessee. As an example, this could be based on the machine hours used, the number of units produced, or the percentage of use against total life of asset in machine hours. If a reasonable method of amortization cannot be determined, the lessor is to use the straight line method as a default.
Similar to the performance obligation approach, lessors would still be required under this method to record a lease receivable. Under the derecognition approach, the cost of the leased property would essentially be amortized in order to accurately record the right of use to the lessee. At the end of the lease term, the remaining property balance would represent the value of the remaining economic life of the asset to the lessor. This remaining asset would be reclassified as a residual asset in the lessor’s balance sheet.
In order to determine the amount to be “derecognized”, the calculation is as follows:
The difference between the lease receivable plus any prepaid rent received by the lessor and the portion of the underlying property that is derecognized would be recognized in the statement of income on the lessor’s income statement. Essentially, the derecognition approach of income recognition is similar to current US GAAP’s recognition of sales-type leases.
The lease receivable after initial recognition and measurement would be measured the same way under either method. The lease receivable would be determined differently than the lessee’s right of use liability, as the PV of the estimated future lease payments discounted using the rate the lessor charges the lessee. The lessee is allowed to use the incremental borrowing rate instead of the rate the lessor charges the lessee. The receivable would include direct costs associated with entering into the lease agreement but would not include any estimated future lease payments due under contingent rentals or measurable residual value guarantees. The last factor that may impact the value of the receivable is based on the lessor’s assumptions. The lessor may make assumptions regarding the lessee’s decisions related to lease renewal or termination options. Again, these conclusions are based on the “more likely than not” scenario which may differ significantly from the lessee’s intentions.
Consideration of adequate factors will help determine the level of exposure to risk or opportunities for future profits that the leased property may hold. During the lease, the lessor should consider any significant contingent rentals based upon performance factors. Lessors should also consider whether there are options within the lease contracts to extend the duration or whether the lessee can terminate the lease agreement prior to maturity. Similar to a traditional capital lease approach, lessors should consider the economic life of the asset after the lease term expires and the value associated with the property at that point. Residual value guarantees will also impact the assessment of exposure as it will reduce lessor’s exposure to risk.
The proposed new standard will also affect how companies account for sale/leaseback transactions. The new standard imposes restrictions on sale and leasebacks transactions, only allowing sale treatment if the sale meets certain criteria which include the transfer of control of the entire asset to the buyer and “all but a trivial amount” of the risks and rewards.
There have been discussions regarding proposing simplified accounting guidance for short-term leases (less than 12 months), however, the action plan has not been fully established at this time.
Potential effects of the proposed standard:
The new standard will likely affect management’s decision making process when it comes to renewing or entering into a new lease. Companies will need to reconsider lease versus buy decision models regarding fixed assets. Unless proactive steps are taken now, companies may also find themselves in violation of financial covenants, such as fixed charge ratios, due to the new standard. The new standard could have a significant impact on debt to equity ratios as well as operating ratios where EBITDA or some other factor is used in the ratio. Companies should also be aware how this change in standard could impact other agreements and contracts. For example, earn-outs or compensation plans based on GAAP income or EBITDA could be impacted. There will be changes in the desired lease terms, durations and structures. Additionally, companies will face a new financial reporting burden associated with the new rules.
Financial statement presentation:
Lessees would present the liabilities included within the estimated future lease payment disclosure separately from other financial liabilities on the balance sheet. Right-of-use assets would be classified separately within property, plant and equipment. Amortization of right-of-use assets and interest expense related to estimated future lease payments would be shown as separate line items instead of within depreciation and amortization and interest expense line items on the income statement. Lease payments under both methods would be included under financing activities in the statement of cash flows.
Lessors under the performance obligation approach would record the net of the lease receivable, the performance obligation and the related asset being leased on the balance sheet as either a net lease asset or liability. Interest income and depreciation expense would be recorded separately in the income statement. This income statement treatment is tentative as there have been proposals made to state these amounts net as well.
Lessors under the derecognition approach would present lease receivables and lease receivables from subleases both separately on the balance sheet. Assets being leased would be stated separately under property, plant and equipment. Income statement presentation may differ depending on whether a company is a dealer or manufacturer of the right-of-use assets. Dealers and manufacturers will be required to have related income and expense shown as separate line items. All other companies would state a single line. Interest income from lease receivables would be stated separately from other interest income.
Disclosures within financial statements will also change. There will no longer be the need for a minimum operating lease payments table. Instead, there will be greater disclosures regarding management’s decision making process to determine the fair value of the leased asset, including increased disclosures on management’s estimates and key assumptions used. For significant leases, separate disclosures are likely to be required explaining how estimates were made and what key assumptions management used in the conclusions. Companies will also be required to discuss how leases may affect their future cash flows.
Other potential disclosure requirements are as follows:
- Key assumptions and judgments
- Any restrictions within lease agreements
- Options to renew or terminate
- Residual value guarantees
- Purchase options
- Amortization methods
- Sale-leaseback transactions
- Information regarding exposure to significant risks or benefits associated with underlying property used in determining whether to apply the performance obligation or derecognition methods
- Information regarding leased assets
- Service obligations
- For lessees, a reconciliation between opening and closing balances of right-of-use assets and liabilities to make estimated future lease payments, disaggregated by the class of underlying property
- For lessors, a reconciliation between opening and closing balances of lease receivables, performance obligation liabilities, and residual assets
- For lessees, a maturity schedule of the liability to make estimated future lease payments showing the undiscounted cash flows on an annual basis for the first five years and a total of the amounts for the remaining years
- For lessors, a maturity schedule of the right to receive lease payments showing the undiscounted cash flows on an annual basis for the first five years and a total of the amounts for the remaining five years
- For lessees, separate disclosure of the minimum future lease obligations
- For lessors, separate disclosure of the minimum future lease receivables to be collected
The proposed new standard is expected to become effective for both public and private companies. It has also been suggested at the effective date (expected to be sometime in 2013), companies will be required to retrospectively apply this standard to all leases held as of the effective date. This suggests that there will not be a grandfathering period related to the implementation of the new standard. The scope of this standard also extends beyond domestic borders. Companies will also have to evaluate and forecast future plans regarding international leases.
The purpose of this ED is to gather comments from the general public regarding their proposed accounting changes. It is a time for business owners, CFO’s, Controllers and other executives to voice their opinions and identify how it will impact their specific businesses. Jointly, the International Accounting Standards Board and the Financial Accounting Standards Board plan to issue a separate document in Q4 2010 seeking input regarding transition methods and potential effective dates. The comment deadline is December 15, 2010.
Comments should be sent to:
Technical Director – File Reference No. 1850-100
Financial Accounting Standards Board
401 Merritt 7
P.O. Box 5116
Norwalk, CT 06856-5116
Or via e-mail to email@example.com
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