On June 13, 2012, after more than a year of deliberation, the International Accounting Standards Board (IASB) and U.S. Financial Accounting Standards Board (FASB) agreed on an approach for accounting for leases that generally will be simpler to implement than some of their earlier and more controversial proposals. The Boards plan to release a joint Exposure Draft in the fourth quarter of this year, with a final pronouncement occurring in 2013.
There have been multiple completing proposals for how to account for leases. Rather than agreeing on a single approach, the Boards concluded that certain types of leases can be treated differently. Some leases will be treated as the purchase of a “right-of-use” (ROU) asset which is financed separately. Equipment leases would start with the presumption that they are ROU assets. Other leases, including most notably real estate leases, would be treated as a payment for access to and use of the underlying asset over time. At first read, this may sound like similar words to describe the same outcome, but the accounting involves different expense timing on the income statement. Specifically:
ROU leases of more than a year would effectively be treated the same as what is a capital lease under U.S. Generally Accepted Accounting Principles. According to the Boards, this means the lessee would record an asset and liability on the balance sheet in a process the Boards described as follows:
a. “Initially recognize a liability to make lease payments and a right-of-use asset, both measured at the present value of the lease payments.
b. Subsequently measure the liability to make lease payments using the effective interest method.
c. Amortize the right-of-use asset on a systematic basis that reflects the pattern of consumption of the expected future economic benefits.
d. Recognize interest expense and amortization expense separately in the income statement.”
The combination of the ROU amortization charge and the interest expense on the lease liability results in a total lease-related expense that would generally decrease over the term of the lease, meaning the expense pattern is front-loaded.
Real estate leases (unless they represent longer-term arrangements for the major part of the underlying asset’s economic life), but can be accounted for using a “practical expedient” of spreading the cost of the lease on a straight-line basis over the life of the lease. This would occur even when the pattern of lease payments is not equal throughout the lease term. Putting aside the smoothing of cost over the lease term, the lessee would present the total payments as lease expense, similar to what is done in the U.S. currently for an operating lease. This approach can also be used for non-real estate leases when the lease term is not for the major part of the economic life of the underlying asset – a distinction that will continue to be debated.
But, for both types of lease, the lessee will recognize a liability on the balance sheet, rather than just disclosing a future payment requirement in the footnotes. Numerous leases that previously did not require balance sheet recognition in the U.S. will now be recorded as a liability. This will change debt ratios on the balance sheet, which potentially can affect loan compliance ratios and covenants. Because of this major change, those negotiating loans and loan agreements should make arrangements now that any changes in accounting standards will not cause a default, but will instead involve a restatement of the covenant itself.
Lessor’s accounting for longer-term leases would be similar to what is currently done for capital leases except that the profit on such leases would be deferred and not recognized until the residual interest in the asset is sold or re-leased.
The challenge with lease accounting has always involved the details of more creative arrangements between lessees and lessors, particularly dynamic arrangements that change. Accounting for these arrangements will continue to be a challenge, and will be the subject of detailed guidance in the full pronouncement. The available guidance already indicates that the final standard will be long and complex, much as lease accounting in the U.S. is currently.
Under the current plan, the following arrangements will not be part of the new lease standard:
Short term leases (a year or less).
Leases to explore for use of minerals, oil, natural gas and similar non-regenerative resources.
Leases of biological assets, including timber.
The convergence of international and U.S. accounting standards has been a long and contentious process, but the Boards now think that they have a lasting consensus that can be implemented. The Boards first published for public comment an Exposure Draft for the new accounting in August 2010, but because of public dissent, agreed to re-expose revised ideas in July 2011.
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