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 their continuing deliberations, the accounting boards are now considering three different approaches to lease accounting. The first approach would basically retain the Type A–Type B model as proposed in the Exposure Draft – Type A for leases of personal property and Type B for leases of real property (land and buildings).
The second approach being considered is a single model, in which lessees would account for all leases as they would for Type A leases. Under this scenario Type B leases would be eliminated.
The third approach being considered would still utilize Type A and Type B leases, however the dividing line would no longer be the type of asset as proposed in the exposure draft. Rather, we would return to the current GAAP distinction between capital and operating leases, albeit now including all leases on the balance sheet. Lessees would account for most capital leases as Type A leases and for most operating leases as Type B leases.
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.
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.