Article: FASB’s Proposed Changes to Accounting for Leases

On August 17, 2010, the FASB issued an exposure draft for a proposed accounting standards update for leases (Leases (Topic 840)). The proposed lease accounting uses a right-of-use concept. The right-of-use concept represents a significant change in the accounting for leases.  The proposed lease accounting shall require all leases to be recorded on the balance sheets of both the lessee and the lessor, similar to the current capital lease accounting.   The proposed standard would apply to all leases including subleases, except for leases of intangible assets, biological assets and leases to explore for or use minerals, oil, natural gas and similar resources.

Changes to Lessee Accounting

Under the right-of-use concept, lessees shall recognize an asset for the right to use the asset, and a liability for future lease payments at the commencement of the lease. The liability would be recorded at the present value of the lease payments discounted using the lessee’s incremental borrowing rate or the rate that the lessor charges the lessee.   The right-to-use asset is amortized on a systematic basis over shorter of the lease term or useful life of the underlying asset.  The liability is amortized using the interest method as payments are made.  As a result, during the initial periods of the lease term the sum of the amortization of the right-to-use asset and the interest expense will generally exceed the amount that was previously recognized as rental expense.

In determining the term of the lease, a lessee shall include renewal options by considering the probability that the lessee will exercise the options.    After the commencement date of the lease, if facts or circumstances indicate that there would be a significant change in the liability since the previous reporting period, lessees shall reassess the carrying amount of the liability.   For changes related to the estimated lease term, the right-of-use asset is adjusted.  For change in the estimated contingent rentals and expected payments under term option penalties and residual value guarantees, arising from current or prior-period activities, the amount of change is recognized in net income. The changes that relate to the future are recognized by adjusting the right-of-use asset.

Changes to Lessor Accounting

The proposed lessor accounting contains two approaches:  (i) the performance obligation approach and (ii)  the derecognition approach.   At the date of inception of the lease, the lessor shall assess under which approach the lease shall be accounted for.   The accounting for the lease will depend on whether the lessor retains exposure to significant risks or benefits related to the leased asset. If the lessor retains significant exposure to such risks, it would apply the performance obligation approach.   If the lessor does not retain such risks, it would apply the derecognition approach.

(i) Performance Obligation Approach

Under the performance obligation approach, the lessor is considered to retain control of the underlying asset.  The lease creates a new asset, the right to receive lease payments and a new lease liability, representing the obligation to permit the lessee the use of the asset during the lease term (performance obligation).  The lessor shall record a receivable for the right to receive lease payments at the sum of the present value of the lease payments and any initial direct costs incurred by the lessor.   The lessor shall record a liability representing the performance obligation at the present value of the lease payments (discounted using the rate the lessor charges the lessee).  The rights to receive lease payments asset is amortized using the interest method and the lease liability would be amortized in a systematic and rational manner based on the pattern of use of the underlying leased asset by the lessee.  A lessor shall present in the income statement interest income on the right to receive lease payments, lease income resulting from satisfaction of the lease liability and depreciation on the underlying asset.

In determining the term of the lease, a lessor shall include renewal options by considering the probability that the lessee will exercise the options.  After the commencement date of the lease, significant changes in the right to receive lease payments arising from changes in the lease term shall be recognized as a change in the performance obligation liability.   If the change results from a change in expected contingent rentals and residual value guarantees, the change shall be recognized in net income if the performance obligation has been satisfied; if not, the change shall be reflected as an adjustment of the liability.

(ii) Derecognition Approach

Under the derecognition approach, the lessor shall recognize a right to receive lease payments and remove (derecognize) a portion of the carrying amount of the underlying leased asset.  The amount of the asset retained by the lessor represents a residual portion for the lessor’s rights in the underlying asset that did not transfer. A lessor shall present in the income statement lease income representing the present value of the lease payments and lease expense representing the cost of the portion of the underlying asset that is derecognized at the commencement date of the lease.    In addition, interest income on the right to receive lease payments is recognized in net income.  After the commencement date of the lease, significant changes in the right to receive lease payments arising from changes in the lease term shall be recognized as a change in the residual asset.   If the change results from a change in expected contingent rentals and residual value guarantees, the change shall be recognized in net income

For short-term leases (maximum terms of one year or less) a lessee can recognize the asset and liability at an undiscounted amount of the lease payments plus initial direct costs.  The lessor may elect to not recognize assets or liability for short-term leases.

The exposure draft also requires additional footnote disclosure of leasing activities.   The comment period for the exposure draft ends December 15, 2010.  The exposure draft did not indicate an effective date.  If the current provisions of the exposure draft are adopted, the resulting lease accounting could have a significant effect on company’s net income, EBITDA, financial ratios and debt covenants.

The contents and opinions contained in this article are for informational purposes only. The information is not intended to be a substitute for professional accounting counsel. Always seek the advice of your accountant or other financial planner with any questions you may have regarding your financial goals. 

By James Jackson