FASB and IASB Lease Accounting “Divergence.”

TimelineFASB/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.

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It’s Finally Here…

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.

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.