In May 2013, the FASB and IASB released an Exposure Draft proposing a new approach to lease accounting. The proposed accounting rules will require recognition of all leased assets as “Right of Use” assets (ROU assets), and recognition of a lease liability (an obligation to make lease payments) on the balance sheet. This treatment will effectively eliminate operating leases as we currently know them, as leases will have to be capitalized. Leases of personal property (for instance, vehicles and equipment) would have accelerated or front-loaded expense on the income statement (Type A leases), while leases of real property (land and buildings) would effectively have straight-line expense on the income statement (Type B leases).
You are probably wondering why the boards elected to treat personal property leases differently from real property leases. The determining factor between Type A and Type B leases is the “level of consumption.” That is, how much of the asset’s value is consumed by the lessee during the lease term. Assets like vehicles and equipment are presumed to lose their values relatively quickly compared to buildings and land, whose values decrease at a much slower pace, and in some instances may actually increase. As a result, the boards came up with a rule of thumb: leases of personal property would be treated as Type A leases by default unless one of the following is true:
- the lease term is insignificant compared to the total economic life of the asset, or
- the present value of the minimum lease payments is insignificant compared to the fair value of underlying asset.
On the other hand, leases of real property are Type B Leases unless:
- the lease term is significant compared to the remaining useful life of the asset, or
- the present value of the lease payments amounts to substantially all the fair value of underlying asset.
The diagram below is an illustration of the lease classification test:
Note that the Boards are not going to quantify the terms “insignificant,” “major,” or “substantially all,” as such companies will have to make their own judgments to justify the classification. My take on this is as follows: The board’s expectation is that almost all personal property leases will be Type A, and almost all real property leases will be Type B. So you’d better have a darned good reason if you are going to classify them otherwise.
In the next two posts, I will cover the actual accounting treatment for Type A and Type B Leases.