Accounting for leasing transactions: the times they are a-changing.
The Current Standard
In November 1976 FASB issued Statement of Financial Accounting Standards 13: Accounting for Leases (SFAS 13). Prior to the issuance of SFAS 13, all leases were accounted for as operating leases. Accordingly, lessees recorded and reported lease payments as rental expenses and neither leased assets nor lease obligations appeared on lessees' balance sheets.
SFAS 13 changed all that when it introduced the concept of the capital lease. Under SFAS 13, leases are presumed to be operating leases. If a lease meets any one of four criteria (see Exhibit 1 on page 20), it qualifies for capital lease treatment and the lessee is required to record and report the underlying assets and related lease obligations on its balance sheet.
Exhibit 1:: Capital Lease Criteria--Current GAAP
1 The lease transfers ownership of the property to the lessee by the end of the lease term.
2 The lease contains a bargain purchase option. A bargain purchase option is a "provision allowing the lessee, at his option, to purchase the leased property for a price which is sufficiently lower than the expected fair value of the property at the date the option becomes exercisable that exercise of the option appears, at the inception of the lease, to be reasonably assured."
3 The lease term is equal to 75 percent or more of the estimated economic life of the leased property.
4 The present value at the beginning of the lease term of the minimum lease payments, excluding payments representing executory costs, equals or exceeds 90 percent of the fair value of the leased property to the lessor at the inception of the lease.
The provisions of SFAS 13, as amended, constitute the current standard for leasing transactions.
The Proposed Standard
The FASB exposure draft issued in August 2010 is part of a joint 'project between the FASB and the International Accounting Standards Board (IASB). The joint project is intended to improve the financial reporting of lease contracts and facilitate the convergence of U.S. GAAP and International Financial Reporting Standards (IFRS).
The FASB and IASB received 760 comments during the four-month comment period after the respective exposure drafts were released.
The volume and nature of the comments received led the two boards to conduct outreach activities to solicit input from financial statement preparers, users and auditors. On Feb. 8, 2013, FASB issued a Project Update that announced its intent to issue a revised exposure draft later in 2013.
One of the goals of the proposed standard is to develop an approach to accounting for leasing transactions that would "ensure that assets and liabilities arising under leases are recognized in the statement of financial position." In general, the proposed standard requires lessees to record and report as an asset the right to use the underlying asset, and to record and report as a liability the obligation to make lease payments over the lease term.
In summary, the major changes included in the proposed standard are: CAPITAL VS. OPERATING LEASE TREATMENT
Under the proposed standard all leases are treated as capital leases. However, the Project Update implies the next FASB exposure draft will allow operating lease treatment for short-term leases, which are defined as any lease that "at the date of commencement of the lease, has a maximum possible term, including any options to renew, of 12 months or less."
Consistent with current GAAP, the proposed standard requires lessees to record lease obligations at the present value of the minimum lease 'Payments, discounted at either the lessee's incremental borrowing rate or the discount rate implicit in the lease. The right-of-use asset is recorded at an equal amount (plus any executory costs incurred by the lessee).
The proposed standard recognizes that, while the lessee may control the underlying asset, title is retained by the lessor. Assets recorded by lessees are not the underlying assets themselves, but the right to use the underlying assets during the lease term. Amortization of the right-to-use asset is based on the lease term rather than the estimated economic life of the underlying asset.
LEASES INVOLVING LAND
Under current GAAP, the only way a lease involving land receives capital lease treatment is if it is, in substance, the purchase of the land by the lessee (i.e., it meets either criterion 1 or criterion 2). Otherwise, leases involving land are accounted for as operating leases.
As a result, balance sheets of corn-pa flies that have possession of land under long-term (e.g., 99 years) leases do not reflect the assets controlled by the company.
Under the proposed standard, leases involving land are treated as capital leases. Lessees will record the right-to-use asset (i.e., the right to use the land) and amortize that asset over the lease term, generally on the straight-line basis. At the conclusion of the lease term the leased land still has value, but the right to use the land has expired and, therefore, has no value.
The FASB exposure draft defines the lease term as not only the initial non-cancellable lease term but also any renewal periods for which it is "more likely than not" that the lessee will exercise renewal options.
The Project Update indicates that the next FASB exposure draft will revert to the definition in current GAAP. That is, renewal periods are not included in the proposed standard unless there is a "significant economic incentive" for the lessee to exercise renewal options.
Significant economic incentives are generally limited to bargain renewal options (i.e., lease payments substantially lower than fair rentals for the underlying asset such that the exercise of renewal options appears, at the inception of the lease, to be reasonably assured) or nonrenewal penalties.
Current GAAP specifically excludes contingent rentals. The FASB exposure draft requires that minimum lease payments reflect a probability-weighted estimate of contingent rentals payable by lessees.
The FASB Project Update indicates that the next FASB exposure draft is expected to exclude contingent rentals unless they are linked to a publicly available index or a rate. Contingent rentals based on sales volumes are excluded. Contingent rentals are recorded as rent expense when incurred.
Impact of the Proposed Standard
As an example of lessee accounting under the proposed standard, assume that lessee company enters into a lease with lessor company with the following terms.
* The lease conveys the right to use the underlying asset to lessee for an initial term of five years with three, five-year renewal options.
* Title is retained by lessor.
* The lessee has the right to purchase the asset at the conclusion of the lease term for fair market value.
* The lessee is also required to make annual lease payments of $10,000 at the end of each year during the initial lease term and during any renewal periods.
The lessee's incremental borrowing rate is 8 percent. The estimated economic life of the underlying asset at the lease inception date is 10 years. The estimated fair market value of the underlying asset at the lease inception date is $100,000. The lessee projects contingent rentals of $1,000 will be made each year during the initial lease term and each renewal term based on the expected use of the underlying asset. Management expects to exercise the first two five-year renewal options. The following compares how this leasing transaction would be recorded and reported under current GAAP and the proposed standard.
AT LEASE COMMENCEMENT DATE
Exhibit 2 (above) provides an evaluation of the lease under current GAAP. The lease does not meet any of the four criteria for capital lease treatment at the inception date. The lessee will account for this as an operating lease. Lessee's balance sheet includes neither the underlying asset nor the lease obligation. However, the lessee's commitment to make five annual lease payments of $10,000 each will be disclosed in the notes to financial statements.
Exhibit 2: Evaluation of Lease Example--Current GAAP Criteria CURRENT GAAP CRITERIA ANALYSIS Capital Lease? 1 Does lease transfer title Underlying asset reverts No of the leased property from to lessor at the end of the the lessor to the lessee? lease term 2 Does the lease contain a Lease does not include a No bargain purchase option?(1) bargain purchase option 3 Is the lease term [greater Lease term =5 years No than or equal to]75% Estimated economic life = of the estimated economic 10 years life of the leased property? 5 / 10 = 50% 4 Present value of minimum Present value of minimum No lease payments [greater lease payments = $10,000 than or equal to]90% x 3.99271 (2)= $39,927 of fair value of the leased Fair value of the leased property? property = $100,000 $39,271 [+ or -] $100,000 = 39.3% (1.) An option to purchase is considered a bargain purchase option if it allows the lessee to purchase the underlying asset during the lease term at a price that is "sufficiently lower than the expected fair value of the property at the date the option becomes exercisable that exercise of the option appears, at the inception of the lease, to be reasonably assured." (SFAS No. 13) (2.) Present value of a five-year annuity at an 8 percent discount rate.
Under the proposed standard, this lease is automatically treated as a capital lease. The lease obligation is recorded at the present value of minimum lease payments, discounted at the lessee's incremental borrowing rate of 8 percent. Minimum lease payments are five annual payments of $10,000. The present value of these payments is $10,000 x 3.99271 = $39,927.
The lessee will record a lease obligation of $39,927 and a right-of-use asset of equal amount. Lease renewals and contingent rentals are not considered in computing minimum lease payments under either set of standards.
DURING THE LEASE TERM
Under current GAAP, the lessee will report rent expense of $11,000 ($10,000 base rent plus $1,000 contingent rentals) each year during the initial lease term and during each renewal period thereafter (Exhibit 3 above). Under the proposed GAAP, the lessee will amortize the lease obligation over the five-year lease term using the effective interest method. The right-to-use asset will be amortized over five years on a straight-line basis (unless there is evidence that the economic benefits of the right-of-use asset are consumed or otherwise used up in some other pattern).
Exhibit 3: Accounting Entries for Lease Example--Current GAAP At the lease commencement date, no entry is required for this lease under current GAAP. Description Debit Credit At the end of each year: Rent Expense $11,000 Cash $11,000 Record lease payment
Payments for contingent rentals are recognized as rent expense as incurred under both current GAAP and the proposed standard. Exhibit 4 on page 22 illustrates the entries the lessee will make on the commencement date and at the end of the first year of the lease term under the proposed standard.
Exhibit 4: Accounting Entries for Lease Example--Proposed Standard Description Debit Credit At commencement date Right of use asset $39,927 Lease obligation $39,927 Record lease obligation and right of use asset. At the end of Year 1 Interest expense 3 $3,194 Lease obligation 4 $6,806 Rent Expense $1,000 Cash $11,000 Amortization expenses $7,985 Accumulated amortization--right of use asset $7,985 Record the first lease payment and the amortization of the right-of-use asset over the 5 year lease term. 3 $39,927 x 8% = S3,194 4 $10,000- $3,194 = $6,806 5 $39,927 5 = $7,985
Implementation of the Proposed Standard
The proposed standard requires retrospective implementation. On the effective date of the proposed standard, operating leases must be recorded and reported as capital leases based on minimum lease payments over their remaining lease terms. It does not require lessees to restate existing capital leases to comply with the new standard.
The proposed standard will have a dramatic impact on the balance sheets of any lessees with significant assets under operating leases. For example, in its 2011 annual report, Southwest Airlines Co. disclosed that more than 27 percent (192 aircraft) of its fleet of 698 aircraft are held under operating leases. Assets and liabilities reported by Southwest Airlines will increase significantly when it implements the proposed standard.
US GMP vs. IFRS
U.S. GAAP is considered rules-based and IFRS is considered principles-based. While U.S. GAAP has traditionally issued accounting standards with bright-line rules, IFRS has looked to the substance rather than the form of transactions in determining the manner with which they should be classified, recorded and reported in the financial statements.
International Accounting Standard 17 (IAS 17), issued by the IASB in April 2001 and amended in December 2003, provides guidance on recording and reporting leasing transactions for those entities reporting under IFRS. IAS 17 states that the classification of a lease "depends on the substance of the transaction rather than the form of the contract."
IFRS generally classifies leases as either operating leases or financing leases, which is akin to capital leases under U.S. GAAP. Under IFRS, leases are presumed to he operating leases unless they meet at least one of five criteria for financing lease treatment (see Exhibit 5 above).
Exhibit 5:: Classification of Leasing Transactions Under Current IFRS
1 Does lease transfer title of the leased property from the lessor to the lessee?
2 Does the lessee have the "option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised?"
3 Is the lease term "for the major part of the economic life of the asset even if title is not transferred?"
4 At the inception of the lease does the present value of minimum lease payments amount to "at least substantially all of fair value of the leased asset?"
5 Are the leased assets of "such a specialised nature that only the lessee can use them without major modifications?"
Comparing Exhibits 1 and 5, it is easy to see the difference between rules-based standards and principles-based standards. Criteria 3 and 4 under U.S. GAAP provide specific cut-offs for classifying leases as either operating or capital leases. Criteria 3, 4 and 5 under IFRS rely on management judgment to determine if the lease is a financing or an operating lease. Management judgment is used to determine:
* If the lease term covers "a major part" of the estimated economic life of the underlying asset (criterion 3).
* If the present value of minimum lease payments "amounts to at least substantially all" of the fair value of the underlying asset (criterion 4).
* Whether the underlying asset is so specialized that it could not be used by another party without "major modifications" (criterion 5).
Since it was issued, SFAS 13 has been amended nine times and interpreted six times by the FASB. Therefore, it is doubtful that the proposed standard will settle all of the issues associated with lease accounting. The proposed standard is part of a joint effort by FASB and IASB to update accounting standards with the goal of converging U.S. GAAP and IFRS. The goal of standards convergence is for the two set of standards to be consistent in recording and reporting similar transactions. The proposed standard for leasing transactions represents another step toward convergence.
Analyses included herein are based on information available at press time. The proposed standard may change substantially prior to the release of the next FASB exposure draft and the eventual issuance of an Accounting Standards Update on lease accounting.
Kyle Meyer, CPA, Ph.D. (ksmeyer@rollins. edu), is an executive in residence and professor of Accounting at Rollins College, Crummer Graduate School of Business.
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|Date:||Apr 1, 2013|
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