Industry Insights

A Major Lease Project Milestone

June 2012
Author:  Jerry Henderson

Jerry Henderson

National Industry Partner

Audit

Manufacturing & Distribution

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At a meeting in London on Wednesday, June 13, 2012, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) met in an attempt to clear the last significant remaining obstacle in reaching consensus on a converged lease standard. 

While both boards have been steadfast in their commitment that long-term leases should be capitalized on the balance sheet, they had been unable to agree on the pattern of expense recognition; this inability to reach a consensus temporarily derailed the project in late February. 

In fact, the boards considered four different alternatives to expense recognition before they reached a compromise on two models, the use of which will generally depend on the nature of underlying asset.

The first model is consistent with the Right of Use (ROU) model recommended in the original exposure draft, which requires lessees to perform both of the following:    

  • Recognize a lease asset amortized on a straight-line basis
  • Recognize a lease liability accreted using the interest method, where interest expense is recognized based on the present value of the lease liability

The ROU approach creates a two-part classification of the expense:  amortization and interest. The recognition of lease liability interest will cause the total expense to be higher in the initial years of a lease and decline as the liability shrinks.

The second model has been termed the Whole Contract model and generally will follow an expense recognition pattern consistent with today’s operating lease expense recognition—a level pattern of expense recognition during the entire lease period. By default, in addition to capitalizing the lease liability and asset, it is likely an additional deferred lease charge or credit will be created on the balance sheet to allow for the level expense recognition.

The model that lease contracts will follow depends on whether a lessee acquires or “consumes” more than an insignificant portion of the underlying asset. The boards decided that, as a practical expedient, this principle will be applied based on the nature of underlying asset. In general, leases of property, e.g., land and/or building, will use the Whole Contract model unless they meet certain criteria similar to those in place under today’s accounting guidance for capital lease classification. Alternatively, leases of assets other than property, such as equipment leases, would follow the ROU model unless their term is “insignificant” to the economic life of the asset or the present value of the fixed lease payments is insignificant to the fair value of the underlying asset.

In reaching these decisions, the boards have cleared the biggest remaining hurdle in the lease project, but there are additional decisions still to be made, including the treatment of related-party lease transactions. Notwithstanding, the boards intend to conclude redeliberations within the next several weeks and issue a revised exposure draft during the fourth quarter of 2012, with a likely comment period of at least 120 days. Those monitoring the project seem to agree the new lease rules will not take effect prior to calendar year 2016.

Please note:  All information above remains subject to additional clarification and/or modification up to the point a final standard is issued.

For more information on these proposed changes, contact your BKD advisor.