To Summarize

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.

The Decision…

At a meeting in London on June 13, 2012, the U.S. Financial Accounting Standards Board and International Accounting Standards Board made a decision on a new approach to account for leases. Under consideration was Approach 1 (previously called Approach A), Approach 2 (previously Approach D) and Approach 3, which is a scenario where some leases would be accounted for under Approach 1, while others would be accounted for under Approach 2.

The Boards ultimately elected to go with Approach 3. Leases of real property (land and buildings), would be recorded under Approach 2 (straight line expense), while other assets (equipment) would be recorded under Approach 1 (accelerated or front-loaded expense).  There are exceptions to this rule. For land and buildings, the method used would be Approach 2 except if the lease term is for the major part of the economic life of the underlying asset, or if the present value of fixed lease payments accounts for substantially all of the fair value of the underlying asset. For equipment, the method used would be Approach A except if the lease term is an insignificant portion of the economic life of the underlying asset, or if the present value of the fixed lease payments is insignificant relative to the fair value of the underlying asset.

Some argue (see this blog from the Wall Street Journal) that this is a return to rules-based versus principles-based accounting. While I certainly understand that argument, it is also true that the “principle” behind the different approaches is whether the lessee is paying to finance acquisition of the asset, or whether it’s paying to simply use the asset. For leases of assets like land or buildings, which have very long useful lives, an argument could be made that a lessee is paying for the right to use the asset, and not acquire it, as long as the lease term is not for the major part of the economic life of the asset. Equipment, on the other hand, has comparatively shorter useful lives, and in most cases lessees are paying to finance acquisition of the equipment. (This is why most leases of equipment have buy-out options, and most real estate leases do not).

Approach 2: – Straight-Line Expense: ROU Asset and Lease Liability

In this post, I’d like to get you acclimated to Approach 2, which, in addition to Approach 1, is being considered by the FASB and IASB as a model for lease accounting for lessees going forward.  I addressed Approach 1 in previous posts; I’d like to focus on Approach 2 here.

Recall that Approach 1 treats the ROU asset and Lease Liability as separate distinct items with different treatment; the ROU asset is amortized straight-line just like any other non-financial asset, while the lease liability is amortized via the effective interest method, just like any other financial liability. Under Approach 2, companies would have to record an ROU asset and a lease liability, just like under Approach 1.  In addition, similar to Approach 1, the lease liability is amortized via the effective interest method. However, under Approach 2, the accretion of the lease liability is not called interest expense, it is simply lease expense. In the same vein, the ROU asset under Approach 2 is not amortized straight-line, and it is not called depreciation expense.  It is calculated as the difference between the average rent, (which is essentially rent expense under current operating lease rules), and the accretion of the lease liability. Sounds complicated? It isn’t. Let’s get back to our initial example from Approach 1.

Recall that we had a 10 year lease with payments of $10,000/yr in years 1 through 5, and $15,000/yr in years 6 through 10. We assumed the lessee’s incremental borrowing rate was 6%, and payments are made in arrears.  Based on this, we calculated the ROU asset (and therefore the initial lease liability) to be $89,339. In order to determine the subsequent values of the lease liability under Approach 2, we use the same amortization schedule that we used under Approach 1:

Period

Cash Due

Accretion

Principal

Liability Balance

0

89,339

1

10,000

5,360

4,640

84,699

2

10,000

5,082

4,918

79,781

3

10,000

4,787

5,213

74,568

4

10,000

4,474

5,526

69,042

5

10,000

4,143

5,857

63,185

6

15,000

3,791

11,209

51,976

7

15,000

3,119

11,881

40,095

8

15,000

2,406

12,594

27,501

9

15,000

1,650

13,350

14,151

10

15,000

849

14,151

0

To calculate the subsequent values of the ROU asset, the first step is to calculate the “average rent” throughout the lease term. This is simply rent expense under the current treatment of operating leases, that is, total cash payments divided by the lease term. In this example, the average rent is $12,500 (125,000 divided by 10 years). For each period, the ROU asset is reduced by the difference between the average rent and the liability accretion, as follows:

Period

Average Rent

Accretion

Reduction in ROU Asset

ROU Asset Balance

0

89,339

1

12,500

5,360

7,140

82,199

2

12,500

5,082

7,418

74,781

3

12,500

4,787

7,713

67,068

4

12,500

4,474

8,026

59,042

5

12,500

4,143

8,357

50,685

6

12,500

3,791

8,709

41,976

7

12,500

3,119

9,381

32,595

8

12,500

2,406

10,094

22,501

9

12,500

1,650

10,850

11,651

10

12,500

849

11,651

 

So here are the entries under Approach 2:

(Dr) ROU Asset              89,339

(Cr) Lease Liability             89,339

To record ROU asset and Lease Liability at commencement.

 

(Dr)  Lease Expense         5,360

(Dr) Lease Liability           4,640

(Cr)  Cash                             10,000

To record lease payment and adjust lease liability in year 1.

 

(Dr) Lease Expense            7,140

(Cr)  ROU Asset                  7,140

To adjust ROU asset in year 1.

 

Note that the entry to record the lease payment and the entry to adjust the lease liability and ROU asset could be made at once, which would be as follows:

(Dr)  Lease Expense         12,500

(Dr)  Lease Liability             4,640

(Cr)  Cash                             10,000

(Cr)  ROU Asset                     7,140

Observing the combined entry above, one should notice an interesting point: Lease expense will be constant throughout the lease term. A concern for some companies about Approach 1 was that it results in higher total expense in the beginning of the lease term, and lower expense in the latter periods. Approach 2 eliminates that problem.

Approach 1 – Accelerated Expense: Part B: Lease Liability

In a previous post, I showed you how to calculate the Right of Use Asset under Approach 1 of the two approaches under consideration by the FASB and the IASB to become the model for lessee accounting for leases. The other approach under consideration is Approach 2, which we will address in a future post. In this post, I want to explain the lease liability under Approach 1.

Calculating the lease liability under Approach 1 is pretty straightforward: upon commencement of the lease, the ROU asset and the Lease liability are equal. In fact, the entry to record commencement of the lease under Approach 1 is a debit to the ROU asset for the present value of the minimum lease payments, and a credit to the Lease liability for the same amount. I should note here that in the previous exposure draft, the initial entry debiting the ROU asset and crediting the lease liability would have been made upon executing the lease, irrespective of when the lease actually starts. This is no longer the case. The entry to record the lease is now made upon lease commencement, not lease execution.

Under Approach 1 the lease contract is comprised of two parts: The right to use an asset, and a liability to make payments. We learned previously that the asset part is treated just like any other non-financial asset, in the sense that it is amortized evenly through the life of the lease. In the same vein, the liability to make payments is treated just like any other financial liability; it is amortized using the effective interest rate. Let’s return to our initial example. Recall that we had a 10 year lease with payments of $10,000/yr in years 1 through 5, and $15,000/yr in years 6 through 10. We assumed the lessee’s incremental borrowing rate was 6%, and payments are made in arrears.  Based on this, we calculated the ROU asset (and therefore the initial lease liability) to be $89,339. In order to determine the subsequent values of the lease liability, we would need to build an amortization schedule, one similar to that used to determine loan balances and payments. The amortization schedule in this example would be as follows:

Period

Cash Due

Interest

Principal

Balance

0

89,339

1

10,000

5,360

4,640

84,699

2

10,000

5,082

4,918

79,781

3

10,000

4,787

5,213

74,568

4

10,000

4,474

5,526

69,042

5

10,000

4,143

5,857

63,185

6

15,000

3,791

11,209

51,976

7

15,000

3,119

11,881

40,095

8

15,000

2,406

12,594

27,501

9

15,000

1,650

13,350

14,151

10

15,000

849

14,151

0

The amortization schedule above gives us all the information we need to make our entries for the lease in this example from commencement to the end of the lease under Approach 1.  Here are the entries:

(Dr) ROU Asset              89,339

(Cr) Lease Liability             89,339

To record ROU asset and Lease liability at commencement.

 

(Dr)  Interest Expense    5,360

(Dr) Lease Liability           4,640

(Cr)  Cash                             10,000

To record lease payment in year 1.

 

(Dr) Depreciation Expense       8,934

(Cr) Accum. Depreciation      8,934

To record amortization of ROU asset at year end.

 

Notice that after year 10, the lease liability will be at zero, and the lease asset would be fully amortized.  Also notice that the expense associated with the lease hits the income statement twice; once as amortization of the ROU asset, and another as interest expense from the lease liability. As a result, rather than having rent expense evenly recorded through the lease term (as is currently the case with operating leases), the expense is “front loaded,” meaning that there is greater expense recorded in the earlier years of the lease term than in the latter years.

Sticking with the same example, if the lease payments were made in advance, then the amortization schedule would look like this:

Period

Cash Due

Interest

Principal

Balance

0

10,000

10,000

84,700

1

10,000

5,082

4,918

79,782

2

10,000

4,787

5,213

74,569

3

10,000

4,474

5,526

69,043

4

10,000

4,143

5,857

63,186

5

15,000

3,791

11,209

51,977

6

15,000

3,119

11,881

40,095

7

15,000

2,406

12,594

27,501

8

15,000

1,650

13,350

14,151

9

15,000

849

14,151

0

 

Note that in this scenario, in period 0 there is no interest due. This is because interest is a function of time, and if a payment is made at the beginning of the lease term then no time has passed for interest to accrue. As such, the entire payment goes against the principal. As I stated earlier, all the examples I have seen from the Boards are with payments in arrears, which is unusual because in practice this is very uncommon. I am yet to see any examples from the boards or accounting firms where payments are made in advance. In the next post we will discuss Approach 2.

 

 

Approach 1 – Accelerated Expense: Part A: ROU Asset

Approach 1 suggests that when a lease is signed, the lessor grants the lessee the right to use an underlying asset. This is called the ROU (right of use) asset. In Approach 1, this asset is accounted for as a nonfinancial asset and is measured at cost less accumulated amortization, similar to any other nonfinancial asset measured at cost (for example, property, plant, and equipment or intangible assets). Put simply, the asset will be recorded and expensed evenly over the life of the lease.  So if the ROU asset is $5,000, and the lease term is 5 years, then there will be amortization of $1,000/yr of the lease asset.

So now we know how to amortize the asset, but how do we calculate the initial ROU asset to begin with? Well, the ROU asset is the present value of the minimum lease payments through the non-cancellable lease term, using the interest rate inherent in the lease (or the lessee’s incremental borrowing rate).  Let’s say we have a 10 year lease with payments of $10,000/yr in years 1 through 5, and $15,000/yr in years 6 through 10. Assume that the lessee’s incremental borrowing rate is 6%, and payments are made in arrears.  Based on this information, the ROU asset would be $89,339, calculated as follows via excel:

  Period Cash Due Present Value
1 10,000 9,434
2 10,000  8,900
3 10,000  8,396
4 10,000  7,921
5 10,000  7,473
6 15,000  10,574
7 15,000   9,976
8 15,000   9,411
9 15,000   8,878
10 15,000   8,376
Total  89,339

Note: To use excel to calculate the present values, use the PV function. Rate should be 6%, nper should be the period, pmt should be 0, FV should be negative cash due. If payments were made in advance, the ROU asset would be $94,700, calculated as follows:

  Period Cash Due Present Value
0 10,000 10,000
1 10,000 9,434
2 10,000 8,900
3 10,000 8,396
4 10,000 7,921
5 15,000 11,209
6 15,000 10,574
7 15,000 9,976
8 15,000 9,411
9 15,000 8,878
Total 94,700

In this example, in period 0, cash due is the same as the present value because the payment is made in advance.  Amortization expense would be $9,470/yr over 10 years (if payments are made in advance), or $8,934/yr if made in arrears. I should stress that in all the examples I’ve seen showing calculations of the ROU asset, both from the FASB, IASB and some of the big four accounting firms, the lease payments are made in arrears. In these examples, they do not even disclose that the payments are made in arrears; I only figured it out when I was trying to re-perform their calculations. In the real world, however, most leases do not work that way. Typically, lease payments are made in advance.  Next we will discuss the lease liability under Approach 1.