FASB/IASB lease accounting “Divergence.” Far from converging, the FASB and IASB have decided to take different routes concerning lease accounting. While both boards decided to capitalize all leases on the balance sheet, the FASB decided to allow companies to use one of two methods to expense the capitalized assets and liabilities: Accelerated Expense Method (called Type A Leases in the Exposure Draft) or Straight line expense method (Type B). The method used depends on if the asset qualifies as an operating lease versus a capital lease under current accounting guidelines. Capital leases would be treated as Type A leases, while operating leases would be considered Type B.
The IASB, on the other hand, has elected to require all companies to use the Accelerated Expense Method for all leases.
The boards stress that they will continue to work together to prepare a converged solution, however this is a very significant difference in approaches.
In this post I will explain Type A leases in detail from the lessee perspective. We will discuss how to calculate the initial and subsequent values of the lease liability and the initial and subsequent values of the Right of Use (ROU) Asset. In a later blog we will discuss how lessees will address the transition from leases that are classified as operating leases under current GAAP to Type A leases under the lease exposure draft.
Example 1: Entity A (Lessee) enters into a 10 year lease of equipment 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 advance. Assume the useful life of the equipment is 20 years, and the fair value is $150,000.
Analysis of Example 1: The first thing to notice here is that the underlying asset in this lease is Equipment, which is personal property. Recall from our previous post that leases of personal property are classified as Type A leases unless:
1) the lease term is insignificant compared to the total economic life of the asset, or
2) the present value of the minimum lease payments is insignificant compared to the fair value of underlying asset.
The lease term is 50% of the useful life of the asset. This is not insignificant. The present value of the minimum lease payments is $94,700. (This is how the present value of the mimimum lease payments was calculated). This is over 60% of the fair value of the equipment, which is not an insignificant amount.
Because the exceptions in 1) and 2) above are not met, this is a Type A lease.
On the lease commencement date (not the execution date), company would record the ROU asset and the Lease Liability. The entry would be a debit to the ROU asset and a credit to the lease liability for the present value of the minimum lease payments, as follows:
Dr. ROU Asset 94,700
Cr. Lease Liability 94,700 To record ROU asset and Lease liability at commencement.
The ROU asset would be depreciated straight-line, so each year the following entry will be made:
Dr. Depreciation Expense 9,470
Cr. Accumulated Depreciation ROU Asset 9,470 To record amortization of ROU asset at year end.
The Lease Liability would be amortized using the effective interest method according to the following table:
The cash column represents the cash paid, the expense is the interest rate times the previous month’s liability balance, the liability reduction is the difference between the cash and the expense, while the liability balance is the difference between the previous month’s liability balance and the liability reduction.
Based on the table above, the following entry would be made to represent the first month’s payment:
Dr. Lease Liability 10,000
Cr. Cash 10,000 To record first lease payment.
Note that the first payment has no interest expense recorded. 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. The entry to record the second lease payment will be as follows:
Dr. Interest Expense 5,082
Dr. Lease Liability 4,918
Cr. Cash 10,000 To record second lease payment.
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 (depreciation expense) 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.
Now that we have covered Type A leases, I will move on to explain Type B leases in a separate post. I will also cover transition guidance from current GAAP to Type A leases in another post.
Post by George Azih: The long awaited Exposure Draft on Lease Accounting was issued this morning (May 16th) by the FASB and IASB. It is 343 pages long, so I’ve got a lot of reading ahead of me. You can read the exposure draft here.
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.
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).