The IASB and the FASB recently issued a joint Discussion Paper on potential lessee accounting rules. This joint effort, which is part of the international harmonization of accounting standards, will significantly revise International Accounting Standard No. 17, Leases. Although the proposed rules establish new requirements that will standardize the lease accounting process, they also will add more complexity to lessee accounting.
Proposed Changes
As expected, the Discussion Paper removes the existing requirement to classify leases as either finance or operating. Unfortunately, this model accords the same accounting to full payout leases as it does to leases with meaningful residual values. This one-size-fits-all model accounts for very different transactions in the same way.
Other big changes include the requirement to record a liability based on the most likely lease term and contingent amounts that may or may not fall due. These assumptions also must be reassessed each reporting period. It is anticipated that these changes will result in:
• An increase in capital, particularly for banks
• Complex and costly judgment calls related to options and contingent rents
• Recognition of liabilities the lessee may have the discretion to avoid
• Increased cost, particularly for smaller lease transactions and smaller, less sophisticated lessees.
The Discussion Paper requires that leases must be capitalized in the financial statements of lessees at the present value of the minimum lease payments, discounted at the incremental borrowing rate. This present value process is no different than the current IAS 17 and FAS 13 requirements. What is different, however, is that lessees now must capitalize their leases based on an analysis of any options to return, renew, or purchase the leased asset.
The liability to pay rents also includes all obligations arising under contingent rental arrangements and residual value guarantees. This determination is based on the lessee’s assessment of contractual and business factors. For example, if the contract contains a renewal option, and renewal of the lease is most likely, the lease is booked at the present value of (1) the payments over the base term, plus (2) the renewal rents over the renewal period.
Once the lease is capitalized, the asset and liability are amortized to depreciation and interest expense. The asset is depreciated over the shorter of the lease term and the economic life of the leased asset. The rental obligation is amortized over the lease term by apportioning the rent payment between interest expense and a reduction of the outstanding principal.
The Discussion Paper requires a reassessment of the lease term, options, contingent rents, and residual guarantees at each reporting date, based on any new facts or circumstances that may arise. Changes in the lease obligation arising from a reassessment of the lease term are recognized as an adjustment to the carrying amount of the right-to-use asset.
Unresolved issues
Although working together on the leasing project, a difference still exists between the FASB and IASB on whether there is a financial reporting difference between a finance lease and a right-to-use (formerly operating) lease. The position of the FASB is that recording depreciation and interest expense for both types of leases strays from the economic substance of an operating lease.
The IASB’s model does not make a distinction between a finance lease and a usage, or operating, lease. Under its model, all leases are capitalized by the lessee and the lease cost consists of depreciation and interest expense. This expense pattern is the same whether the lease represents an in-substance financing or a usage agreement. Under the FASB’s approach, the expense would match the right to use the equipment, which, for accounting purposes, is an equal amount each period.
Lessor accounting
The decision was made to defer consideration of lessor accounting. Consequently, lessor accounting has not been addressed in this project, other than at a very high level. Under the proposed model, lessors do not classify a lease as finance or operating. This model is essentially the same as direct financing lease accounting under FAS 13 and the approach used for finance leases in IAS 17.
Although the issue of FAS 13 leveraged lease treatment is not yet resolved, it is likely that it will be eliminated in a new lessor accounting standard. There also is some uncertainty as to whether or not sales-type lease accounting for vendor lessors will be retained.
Conclusion
The expectation is that leasing volumes will be negatively impacted by the proposed capitalization requirements. There certainly will be some costs incurred associated with technical debt default or renegotiating debt contracts to avoid technical default. There also may be costs for revising managerial compensation contracts due to the impact of capitalization on common performance measures.
The good news is that lessees will continue to utilize leasing for its many other real benefits such as cash flow savings and flexibility. Just as in the past, the leasing landscape has changed and, just as in the past, lessors will successfully adapt to the new environment.