Trent Parten

In the paper the FASB and the IASB discuss a proposed change in lease accounting. It would require the lessee to recognize an asset representing its right to use the leased item and a liability for its obligation to pay rentals. This would remove the current provision in U.S. GAAP allowing some leases to be expensed as incurred with no asset or liability recognized. This approach aims for leases to be accounted for consistently across sectors and industries. The proposals are intended to improve the transparency, credibility and usefulness of lease accounting.

Accounting for Leasehold Obligations

Current guidance classifies leases in two categories—finance leases (capital leases under U.S. GAAP) and operating leases. Such classification is determined under U.S. GAAP by four key tests:

• Does title of the asset transfer at the end of the lease?
• Does the lease contain a bargain purchase option?
• Is the term of the lease at least 75 percent of the economic useful life of the asset?
• Is the present value of the future minimum lease payments at least 90 percent of the fair market value of the asset?

If the answer is “yes” to any of these questions, then the lease is required to be capitalized and recorded on the balance sheet. The asset is recorded at cost and the lessee’s obligation to pay is measured by discounting the future minimum lease payments using the interest rate implicit in the lease.

If the answer to all four questions is “no,” then the lease is considered to be an operating lease and lease payments are expensed as incurred through the statement of operations.

Proposed Approach

If adopted, the proposed guidance would essentially mean all leases would be capitalized. As with current guidance, the boards have maintained the lessee’s right-of-use asset would initially be measured at cost. The boards have proposed that measuring the lessee’s obligation to pay rentals should be discounted using the lessee’s incremental borrowing rate.

The boards also discussed whether to require the lessee to revise its obligation to pay rentals to reflect changes in the incremental borrowing rate. The FASB tentatively decided not to require reassessment of the lessee’s incremental borrowing rate.

Under current U.S. GAAP, capital leases are recorded based on the fixed noncancelable term of the lease. The accounting treatment for leases with options would change under the proposed guidance. The boards decided the lessee would consider the most likely outcome of an option based on contractual, non-contractual and business factors. For example, a ten-year lease with a five-year option would be recorded either as a ten-year or fifteen-year lease depending on the lessee’s particular business factors. Lessees would reassess the terms of each lease at each reporting date on the basis of any new facts or circumstances. Changes in the obligation to pay rentals arising from reassessment of the lease term would be recognized as an adjustment to the carrying amount of the asset.

The following example demonstrates the difference between an operating lease under current guidance versus a lease under the proposed guidance:

This proposed treatment will require more monitoring and record keeping and will result in the initial years of the lease term reducing profits. Accounting for all leases as capital leases will affect financial ratios, measurement of net income and other key financial indicators. These changes may result in the need to revise debt covenants and other affected contractual provisions with lenders, franchisors, vendors, regulators, etc.

The following will be excluded from the scope of the proposed new lease guidance:

• Contracts that represent the purchase (lessee) or sale (lessor) of the subject item. The staff will develop criteria for an entity to use in determining whether an arrangement is the purchase or sale of an asset and is not a lease
• Leases to explore for or use natural resources, such as minerals, oil and natural gas

At its current pace, the FASB could release an exposure draft in 2010, and a formalized standard could be in place before 2012. If the final standard corresponds with the preliminary views document, it would affect all leases in existence at the effective date. Lessees would recognize an obligation to pay rentals and the right-to-use asset for all outstanding leases at the effective date. The obligation and the right-to-use asset would be measured at the present value of the minimum lease payments discounted using the lessee’s incremental borrowing rate at the effective date.

Updates to this proposed guidance can be monitored on the FASB’s project webpage.