Proposed Lease Accounting Changes
Leasing is an important aspect of running a business for many organizations, whether it’s a small family business, a large public company, or a not-for-profit organization. In May, the Financial Accounting Standards Board (FASB) released a revised exposure draft of proposed lease-accounting standards that would drastically change the way organizations account for and disclose lease transactions in their financial statements. What do these proposed lease accounting changes mean?
The original exposure draft was issued in August 2010 in response to long-established concerns associated with existing lease accounting. The main concern was the lack of recognition of assets and liabilities arising from what is now classified as an operating lease. In order to provide a more transparent representation of the transactions for financial reporting across all organizations, the FASB set out to develop a new approach to lease accounting that would require recognition of these assets and liabilities.
The most recent lease-accounting exposure draft proposes a dual-recognition approach where the recognition, measurement, presentation, and disclosure will depend on whether the lessee is expected to consume more than an insignificant portion of the underlying asset.
So what transactions will fall under this new standard? A lease is defined in the updated exposure draft as “a contract conveying the right to use an asset for a period of time in exchange for consideration.” A contract would be defined as “an agreement between two or more parties that creates enforceable rights and obligations.” Therefore, there may be transactions that are currently treated as leasing transactions that would not fall under the scope of this new definition. Issues to consider would be related party transactions that are not written and differing state regulations on what constitutes an enforceable obligation.
To lay the groundwork for how the changes will affect financial reporting, the highlights of the proposed standard are as follows.
The dual-recognition approach creates two types of lease transactions, a Type A lease and a Type B lease. These are not to be confused with the existing operating and capital lease classifications used today.
The Type B lease is the more straightforward of the two options. It would typically include leases of property (real estate) unless the lease term is for the major part of the remaining economic life of the asset, or the present value of the lease payments accounts for a substantial part of the fair value of the asset.
The lessee would:
- Recognize a right-of-use asset and a lease liability, initially measured at the present value of lease payments; and
- Recognize a single lease expense on a straight-line basis.
- The lessor would:
- Continue to recognize the underlying asset; and
- Recognize lease income over the lease term typically on a straight-line basis (similar to the current ‘operating lease’ treatment used currently).
Meanwhile, a Type A lease would typically include leases of assets other than property, which might include equipment or vehicles. However, if either the lease term is for an insignificant portion of the economic life of the underlying asset or the present value of the lease payments is insignificant compared to the fair value of the underlying asset, the lease may be treated as a Type B lease. There is no threshold for the determination of ‘insignificant,’ and, therefore, there will be some judgment involved in determining the treatment of each lease transaction.
In the Type A scenario, the lessee would:
- Recognize a right-of-use asset and a lease liability, initially measured at the present value of lease payments; and
- Recognize interest expense on the lease liability and amortization of the right-of-use asset.
The lessor would:
- De-recognize the underlying asset (or portion thereof), cease depreciation, and recognize a right to receive lease payments (the lease receivable) and a residual asset (representing the rights the lessor retains relating to the underlying asset);
- Recognize interest income on both the residual asset and the lease receivable; and
- Recognize any profit or loss relating to the lease at the commencement date.
When determining the lease term or the number of payments to include in the present value calculation for both Type A and Type B leases, the term of lease would include the non-cancellable period of the lease plus options to extend if the lessee has significant economic incentive to exercise the option. Significant economic incentive could include bargain renewal rates, relocation costs, or an investment in leasehold improvements.
For leases with a maximum length of 12 months or less (including any option to extend), the lessor and lessee can make an accounting policy election, by class of underlying asset, to apply simplified accounting similar to current operating-lease treatment.
When determining the lease payment itself, most variable lease payments would be excluded unless they are based on an index or a rate (for example, inflation).
Due to the decisions that will go into the initial recognition of a lease, the facts and circumstances of the transaction may need to be re-evaluated on an annual basis to determine whether any adjustments are needed. Re-evaluation may be needed for any of the key factors, including the lease term, lease payments, or the discount rate used to calculate the present value of the lease payments. There is guidance available on when these factors should or should not be re-evaluated. In addition to the changes in the accounting, there will be additional disclosure requirements as well.
So how will this change impact your company? Among the possible effects are:
• Changes to key performance indicators and other performance-evaluation metrics;
• Effects on loan covenants that rely on certain metrics;
- The possibility of new book-tax differences;
- Possible changes needed for budgeting and planning processes;
- Challenges in isolating different components of a lease and separating lease payments and service payments; and
- Challenges in re-evaluation and reassessment, especially if you have numerous leases.
- The change in accounting will be required to be applied retrospectively to beginning of the earliest period presented on your financial statements. An effective date has not been provided at this point.
If you have further questions on how this proposed standard would impact your business or organization, be sure to contact your accounting advisor.
Kelly Dawson is an audit and accounting manager for the Holyoke-based public accounting firm Meyers Brothers Kalicka, P.C.; (413) 322-3495; kdawson@mbkcpa.com
This material is generic in nature. Before relying on the material in any important matter, users should note date of publication and carefully evaluate its accuracy, currency, completeness, and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances.
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