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The FASB/IASB Lease Accounting Project

On August 17, 2010, the Financial Accounting Standards Board and the International Accounting Standards Board (the boards) jointly issued exposure drafts (EDs), Leases, that would establish an accounting model to ensure that assets and liabilities arising under leases are recognized in the statement of financial position.

Among the key provisions of the EDs, lessees and lessors would apply a right-of-use model in accounting for all leases(including leases of right-of-use assets in a sublease) other than leases of biological and intangible assets, leases to explore for or use natural resources, and leases of some investment properties. Under this model, a lessee would recognize

a. an asset representing its right to use the leased asset for the lease term (measured initially at the present value of the lease payments plus any initial direct costs).

b. a liability to make lease payments (measured initially at the present value of the lease payments).

This differs from the current U.S. GAAP and IFRS model, which separates leases into two categories:

a. Capital leases (recognize an asset and a liability)

b. Operating leases (do not recognize an asset and liability)

Under the model in the EDs, all leases would result in asset and liability recognition. A lessor would recognize an asset representing its right to receive lease payments and, depending on its exposure to risks or benefits associated with the underlying asset, would either

a. recognize a lease liability while continuing to recognize the underlying asset (a performance obligation approach) or

b. derecognize the rights in the underlying asset that it transfers to the lessee and continue to recognize a residual asset representing its right to the underlying asset at the end of the lease term (a derecognition approach).

Assets and liabilities recognized by lessees and lessors would be measured on a basis that

a. assumes the longest possible lease term that is more likely than not to occur, taking into account the effect of any options to extend or terminate the lease.

b. uses an expected outcome technique to reflect the lease payments, including contingent rentals and expected payments under term option penalties and residual value guarantees, specified by the lease.

c. is updated when changes in facts or circumstances indicate that there would be a significant change in those assets or liabilities since the previous reporting period.

The boards received nearly 800 comment letters on the EDs, expressing a variety of concerns.1 The boards have been redeliberating the EDs, and have tentatively decided to significantly change some provisions of the EDs, to refine others, and to continue redeliberating still other provisions.

Significant Changes to the EDs

Following are some of the more significant changes the boards have tentatively agreed to make to the EDs.

Lessor Accounting

The boards tentatively agreed to require a lessor to apply a “receivable and residual” accounting approach to all leases except for short-term leases and leases of investment property measured at fair value. Under this approach, a lessor would recognize a right to receive lease payments at the present value of those lease payments, and subsequently measure at amortized cost using the effective interest method..   The lessor would also recognize a residual asset at the date of the commencement of the lease, measured as an allocation of the carrying amount of the underlying asset. 

The initial measure of the residual asset comprises two amounts:

  1. The gross residual assets, measured at the present value of the estimated residual value at the end of the lease term, and
     
  2. Deferred profit, measured as the difference between the gross residual asset and the allocation of the carrying amount of the underlying asset.

 

The gross residual asset would subsequently be accreted to the estimated residual value at the end of the lease term.  The lessor would not recognize any of the deferred profit in P&L until the residual asset is sold or re-leased.

The gross residual asset and the deferred profit would be presented together as a net residual asset.

For short-term leases that the lessor elects not to account for under the receivable and residual approach and leases of investment property measured at fair value, the lessor would continue to recognize the underlying asset and recognize lease income over the lease term on a systematic basis.

Short-Term Leases

The EDs proposed giving lessors an option to elect, on a lease-by-lease basis, not to recognize in the statement of financial position assets and liabilities from a short-term lease, nor derecognize any portion of the underlying asset. In contrast, the EDs proposed giving lessees an option to elect, on a lease-by-lease basis, to measure (1) the liability to make lease payments at the undiscounted amount of the lease payments and (2) the right-of-use asset at the undiscounted amount of lease payments plus initial direct costs. Short-term leases would, nevertheless, be required to be capitalized by the lessee under the EDs.

The boards have tentatively agreed to instead give lessees an option similar to the option proposed for lessors, that is, to elect, by class of underlying asset, not to recognize assets and liabilities from a short-term lease in the statement of financial position. Lease payments would be recognized in profit or loss on a straight-line basis over the lease term, unless another systematic and rational basis is more representative of the time pattern in which use is derived from the underlying asset.

Lease Term

The boards tentatively decided that the lease term should be defined as the contracted noncancellable period plus any option periods for which there is a clear economic incentive for the lessee to exercise the option, or for an entity not to exercise an option to terminate the lease. This differs from the EDs’ definition as the longest possible lease term that is more likely than not to occur, taking into account the effect of any options to extend or terminate the lease, which almost all respondents to the EDs disagreed with.

The boards also tentatively decided that the lease term should be reassessed only when there is a significant change in relevant factors such that the lessee would then either have, or no longer have, a significant economic incentive to exercise any options to extend or terminate the lease.

Variable Lease Payments

The boards tentatively decided that the following are the only variable lease payments to be included in the measurement of the lease liability or receivable:

a. Variable lease payments that are based on an index or rate (measured initially based on the spot rate)

b. Variable lease payments that meet a high reliability threshold (such as reasonably certain)

Definition of a Lease

The boards have agreed to clarify the EDs’ definition of a lease, which was similar to definitions in U.S. GAAP and IFRS.  Under the clarified definition, whether a contract contains a lease would be determined on the basis of the substance of the contract by assessing whether—

  • The fulfillment of the contract depends on the use of a specified asset.  A specified asset must be explicitly or implicitly identifiable.  A physically distinct portion of a larger asset of which a customer has exclusive use is a specified asset; a capacity portion of a larger asset that is not physically distinct is not a specified asset.
     
  • The contract conveys the right to control the use of a specified asset for a period of time.  A contract would convey that right if the customer has the ability to direct the use, and receive the benefits from use, of a specified asset throughout the lease term.

Sale and Leaseback Transactions

The boards tentatively decided that an entity should apply the control criteria described in their revenue recognition project to determine whether a sale has occurred, rather than the more restrictive criteria proposed in the leases EDs. The effect is that more transactions would qualify for sale-leaseback accounting than under the EDs.

Timing

The boards initially planned to issue final standards by June 30, 2011, however they now plan to re-expose the standards in the first half of 2012.

 

1 The AICPA Financial Reporting Executive Committee's comment letter can be found at http://www.aicpa.org/InterestAreas/Accounting AndAuditing/Resources/AcctgFinRptg/AcctgFinRptgAdvocacy/DownloadableDocuments/AICPA_Leases_Comment_Letter.pdf.

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