Leases are common transactions encountered by many entities and often involve significant assets and liabilities. The current lease accounting model has been criticized for various reasons, including assertions that it is unnecessarily complex, includes arbitrary bright line rules, and results in financial reporting that emphasizes form over substance. In addition, the financial reporting standards resulting from the project are expected to further convergence of International Financial Reporting Standards (IFRS) and US GAAP. Because of those reasons, FASB and IASB proposed new lease accounting model on a “Discussion Paper, Preliminary Views, Leases” issued on March 19, 2009. What is the overall model in the discussion paper, and how does it compare to current US GAAP’s Lease Accounting? Read on…
FASB and IASB tentatively decided to adopt an approach to lessee accounting that would require the lessee to recognize:
- an asset representing its right to use the leased item for the lease term (measured initially at cost, which equals the present value of the lease payments).
- a liability for its obligation to pay rentals (measured initially at the present value of the lease payments).
This differs from the current US GAAP model which separates leases into two categories:
- Capital leases (recognize an asset and liability); and
- Operating leases (do not recognize an asset and liability). Under the model in the document papers, all leases would result in asset and liability recognition.
Some of the other key provisions of the new lease accounting model:
- Includes an amortized cost-based approach to subsequent measurement of both the obligation to pay rentals and the right-of-use asset, which is similar to US GAAP for capital leases.
- Provides that the lessee should recognize an obligation to pay rentals for a specified lease term (the most likely lease term). For example, in a 10-year lease with an option to extend for five years, the lessee must decide whether its liability is an obligation to pay 10 or 15 years of rentals. The boards tentatively decided to provide guidance on the factors to consider when determining the lease term. Their preliminary view is that the guidance should specify that contractual, non-contractual, and business factors should be considered in determining the lease term. The lessee’s intentions and past practices would not be considered. Current US GAAP (for capital leases) provides explicit guidance concerning the factors to consider when determining the lease term, many of which are likely to be considered under the proposed model.
- requires reassessment of the lease term at each reporting date on the basis of any new facts or circumstances. Current US GAAP for capital leases includes explicit guidance for facts and circumstances that may result in either a reclassification of the lease between a capital and operating lease or reporting of a new lease.
- requires that the lessee’s obligation to pay rentals should include amounts payable under contingent rental arrangements. The IASB has chosen a model that measures those liabilities using a probability weighted approach, while the FASB has chosen a most likely approach. Current US GAAP generally provides that contingent rent be expensed as incurred.
Advantages and Disadvantage Of The New Lease Accounting Proposed Model?
Advantages: Financial statement users would have more information about all leases, including those currently classified as operating leases, and financial statements between entities would be more comparable. The proposed model would eliminate much of the complexity and structured transactions that exist with the current model.
Disadvantages: By requiring all leases to be recognized on the balance sheet, the proposed model would result in significantly more bookkeeping and reported assets and liabilities than the current model.
How will the New Lease Accounting affect Entities and Accountants?
Lessees will be required to perform significantly more monitoring and record-keeping, particularly for leases currently classified as operating leases. Auditors will be relieved of making some of the subjective judgments required under the current model, but will be required to make other judgments (such as most likely amounts), and need to perform more detailed audit procedures due to the increased quantity of leases reported, and the necessity of assuring that all leases are reported.
The discussion paper for public comment as a step preceding the development of an exposure draft of a proposed standard. The discussion paper focuses primarily on lessee accounting. The FASB and IASB request views on a few lessor accounting issues, but expect to address lessor accounting in more detail at a later stage in the project.