The long-awaited revised Exposure Draft of the Lease Accounting standard was issued May 16, 2013, by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). This is an important development for any business or lending institution involved in leasing. The proposed standard aims to improve accounting to enable financial statement users to better understand an entity’s assets and obligations related to leasing activities and to improve disclosures about those activities. The proposal requires assets and liabilities from leases to be recognized in the statement of financial position and applies to both commercial and not-for-profit organizations. FASB and IASB seek additional comments on these proposed principles and standards.
This article briefly highlights the major elements in the 343-page exposure draft. Much will be written about the topic between now and the Sept. 13, 2013, comment deadline. It will take a while to understand how the proposal could affect your entity’s accounting for leases. Your Clark Nuber professional will be able to discuss the impact with you. You should also be aware that an implementation or effective date has not been set. That will come at the final deliberation of the proposal.
Proposed Right-of-Use Model
A lease conveys the right to use an asset for a period of time in exchange for compensation. Under the model, the Lessor transfers the “Right-of-Use” asset to the Lessee, who becomes obligated for lease payments. These assets and liabilities are recognized on the balance sheet. The subsequent accounting depends upon how much of the life of the asset is consumed during the lease. Most equipment and vehicle leases are deemed to consume “more than an insignificant” portion of the economically useful life of an asset. Most real estate leases are deemed to consume “not more than a significant” portion of the life of the asset. These two different leases are called Type A and Type B, respectively. From the perspective of the lessee, the important point to remember is that both types of leases appear on the balance sheet. The only difference is in how they come off of the balance sheet and are presented in the Operating and Cash Flow statements. Lessor accounting is somewhat different, but beyond the scope of this brief introduction.
Lessee Accounting Overview
Type A Leases (most leases of equipment and vehicles):
Balance Sheet – “Right-of-Use” asset and Lease Liability initially measured at present value of the contractual lease obligation.
- Income Statement – Amortization expense (for the “Right-of-Use” asset) over the life of the lease and Interest Expense for the present value discount on the lease liability.
- Cash Flow Statement – Cash paid for principal payments (financing activity).
Type B Leases (most leases of real estate):
- Balance Sheet – “Right-of-Use” asset and Lease Liability initially measured at present value of the contractual lease obligation.
- Income Statement – Single lease expense on a straight-line basis.
- Cash Flow Statement – Cash paid for lease payments within operating activities.
Exceptions and Complications
The Exposure Draft of the Lease Accounting proposal contains many simplifications over the initial 2010 proposal, primarily relating to the need for fewer judgments and extensive computations. For example, a lessee can make an accounting policy election to not recognize an asset and liability for leases with a maximum term of less than 12 months. (Very few commercial leases will meet this permissible exception.) Variable lease payments and renewal options have also been made less complex in the new proposal. Non-public entities have also been granted some relief from the extended disclosures and some calculations. Accounting for related party leases is also somewhat less subjective but still adheres to the proposed model. Leases involving donated property, not uncommon in not-for-profit organizations, are not covered by the new proposal. Because of the complexity of these features, consult a Clark Nuber professional for further details.
Existing leasing standards have long been criticized as being too rules-based, subject to contractual manipulation, and short on important disclosures about an entity’s leasing activity. Leases touch almost all entities and the FASB and IASB have made this effort to revise lease accounting rules one of the touchstones of convergence of improved global accounting standards. It appears that they have listened to the major concerns of both users and preparers in producing Round 2. Stay tuned for Round 3. In the meantime, take inventory of your Type A and B leases and do some modeling to get a feeling for how the new standard could affect the look of your financial statements and the impact of changes on your key financial ratios and covenants.
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