Proposed Lease Accounting Standard – Impact on Lessors
Author: Tim J Wilson
On August 17, 2010, the Financial Accounting Standards Board and International Accounting Standards Board issued an exposure draft of an accounting standard update—Leases, Topic 840—that will have implications for both lessees and lessors.
Current accounting standards for leases by lessors contain several variables that must be evaluated to determine the proper treatment in the lessor’s financial statements. Currently, once a lessor enters a lease, the lessor must evaluate which category the lease falls into: sales, direct financing, leveraged or operating. Key distinctions are made in the current accounting standards for real estate leases versus other types of assets.
In the exposure draft, the lessor would recognize an asset based on the right to receive lease payments in the future. The lessor would then follow a performance obligation approach or derecognition approach, depending on the risks and benefits of the asset being leased, as follows:
- Recognize a liability equal to the asset recorded, while continuing to leave the underlying leased asset recorded on the financial statements (performance obligation approach).
- Lessors not required to follow the performance obligation approach would follow the derecognition approach; revenue would be recognized, and the leased asset would be recorded as cost of sales.
The measurement of assets and liabilities recorded under the new accounting standard would be based on the following assumptions:
- The longest lease term is more likely than not to occur, including any lease terms that allow for extensions, renewals or terminations.
- The lease payments will include expected payments contained within the lease, such as regular scheduled payments, contingent rentals, term option penalties and residual value guarantees.
- If facts and circumstances change during the lease term and it is determined that this would cause a significant change in recorded assets and liabilities, the carrying amounts will be updated.
Understanding all lease terms will be important for lessors under the proposed standard. In addition to the financial terms of the lease, the interpretation of risks and benefits associated with the underlying asset will have a significant impact on the proper accounting and financial reporting. If the lessor retains exposure to significant risks or benefits, the lessor will continue to report the underlying asset in their financial statements for accounting purposes.
The lessor will record the initial asset based on the present value of lease payments to be received, discounted using the interest rate the lessor charges the lessee. This rate could be the lessee’s incremental borrowing rate, the implicit rate in the lease or for property leases and the yield on the property.
In addition to the impact on the basic financial statements for lessors, the proposed standard will require additional disclosures in the footnotes to the financial statements. These additional disclosures will focus on judgments and assumptions identified in the initial measurement and recording of the assets and liabilities. When facts or circumstances significantly change during a lease term, they will need to be disclosed.
Leases of intangible assets, natural resources, biological assets and leases of investment property measured at fair value are excluded from the proposed standard.
The exposure draft does not currently include any grandfathering of existing leases for lessors, nor does it include an effective date. The comment period ends on December 15, 2010, and a final standard is expected in mid-2011.
If your organization is involved in leasing activity from the lessor’s perspective, you should evaluate the impact of the proposed standard. It could have a significant impact on the basic financial statements, disclosures and credit agreements you have in place. Please contact your BKD advisor to discuss this topic or related matters.