As I noted in a prior post, the FASB and IASB have made a decision on a new approach to account for leases. Leases of land and buildings would effectively have straight-line expense on the income statement (Approach 2), while leases of assets other than land and buildings would have accelerated or front-loaded expense (Approach 1). I covered Approach 1 in two parts: here and here. I covered Approach 2 here. In this post, I’d like to summarize the two approaches by highlighting the similarities and differences.
Similarities between Approach 1 (accelerated expense) and Approach 2 (straight-line expense):
- Both Approaches require a right-of-use asset and a lease liability to be recorded on the balance sheet.
- The initial measurement of the right-of-use asset and lease liability is the same under both methods: It is the present value of the lease payments over the lease term.
- The subsequent measurement of the lease liability is also the same under both methods: The liability is accreted via the effective interest method using either the rate inherent in the lease if known, or using the lessees’ incremental borrowing rate at lease commencement.
Differences between Approach 1 and Approach 2:
- The subsequent measurement of the right-of-use asset is different in both Approaches:
- Under Approach 1 (accelerated expense), the asset is depreciated via straight-line over the lease term. When this depreciation expense from the asset is added to the interest expense from the liability, it gives a higher total expense in the early periods of the lease term, because the liability is highest at the beginning of the lease, and decreases as payments are made. It is because of this higher total expense—interest from the liability plus amortization from the asset—that this lease is called the “accelerated expense” approach. For a detailed explanation of this approach, click here and here.
- Under Approach 2 (straight-line expense), the lessee would have to calculate the average rent during the period (similar to calculating the straight-line expense for operating leases under current accounting rules). The lessee would then determine the decrease in the right-of-use asset by subtracting the accretion of the liability from the average rent. To learn more about this approach, click here.
- Under Approach 1, there are two expenses on the income statement: Interest expense (from the liability) and amortization expense (from the right-of-use asset). Under Approach 2, there is only one expense on the income statement, lease expense.
- Under Approach 1, a portion of the lease payments will be classified as cash used in financing activities on the statement of cash flows. Under Approach 2, all lease payments would be classified as operating activities.