Leases project: finally getting straight?
(First of two parts)
By John T. Villa
First Published in Business World (7/23/2012)
When the original Exposure Draft on Leases was issued in 2010, many users felt that the cost of implementation may outweigh the benefits, given the complexity involved and the potential effects on some financial metrics. There were complaints that the front-loading of income and expense for most leases did not reflect their underlying economics.
As a result, in June 2012, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) [together, the Boards] tentatively agreed to change the income and expense recognition pattern and related income statement presentation for certain leases. This is part of their continuing effort to enhance the models proposed in the leases project. The Boards expect to issue a new leases exposure draft for comment during the fourth quarter of 2012.
The Boards decided to distinguish between two types of leases, namely: 1) straight-line leases and 2) accelerated leases. Both lessees and lessors would use the same criteria to classify leases. The two types would also have different lease expense and income recognition patterns.
The Boards developed a principle for classifying leases based on whether the lessee acquires and consumes more than an insignificant portion of the underlying asset over the lease term. The lease expense for leases that convey a relatively small percentage (i.e., an insignificant portion) of the life or value of the leased asset should be recognized evenly over the lease term. However, the Boards decided to simplify the classification assessment based on the nature of the underlying asset being leased. Accordingly, leases would be classified as follows:
a) Leases of property (i.e., land, building or part of a building) would be classified as straight-line leases, unless the lease term is for the major part of the economic life of the underlying asset, or the present value of fixed lease payments accounts for substantially all of the fair value of the underlying asset. The term “fixed lease payments” is yet to be defined by the Boards and it may or may not be in substance similar to the concept of minimum lease payments under the current lease standard.
b) Leases of assets other than property (e.g., equipment) would be classified as accelerated leases, unless the lease term is an insignificant portion of the economic life of the underlying asset, or the present value of the fixed lease payments is insignificant to the fair value of the underlying asset.
Currently, there appears to be limited guidance on what would constitute a “major part” and “insignificant portion.” These are added areas of judgment, for which we hope the Boards will provide guidance.
Similarities between the types of leases
Except for short-term leases (i.e., those with maximum lease terms of one year or less), all leases would be recognized on the balance sheet. The initial measurement of the right-of-use asset and liability to make lease payments (lease liability) would be the present value of the fixed lease payments over the lease term. The subsequent measurement of the lease liability would also be the same for both types of leases, where accretion would be calculated using the interest method (i.e., using a constant interest rate) and lease payments would reduce the lease liability.
Differences between the types of leases
For straight-line leases, lessees would calculate both the periodic straight-line expense similar to determining straight-line expense for operating leases under current accounting, and the accretion of the lease liability (using the interest method). Rather than amortizing the right–of-use asset on a straight line basis, lessees would calculate the amortization expense by subtracting the period’s accretion of lease liability from the periodic total straight-line expense amount. By applying this ‘residual’ calculation method for the amortization expense, the total expense recognized will be the same amount as the straight-line expense for operating leases under current accounting rules.
Total expense for straight-line leases would be presented as a single line item (e.g., lease or rent expense) on the income statement.
For accelerated leases, lessees would separately amortize the right-of-use asset (generally on a straight-line basis) and recognize interest expense for the accretion of the lease liability. This accelerates or front-loads the total expense, because interest expense is generally higher during the earlier part of the lease term. The total expense to be recognized is the sum of the accretion expense and the straight-line amortization of the right-of-use asset. Notably, this is consistent with the expense recognition approach in the original exposure draft issued.
Amortization and interest expense would be presented either separately or with other amortization and interest expense, respectively, on the income statement.
In next week’s article, we will discuss lessor accounting, as well as the possible implications of the proposed straight-line lease accounting standard for industry practitioners.
John T. Villa is a Partner of SGV & Co.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.