U.S. GAAP requires that a lease be noncancelable before it can be capitalized. A lease must meet one or more of four very specific criteria before it is considered a capital lease:
Ownership of the leased asset is transferred to the lessee.
A bargain purchase option is included in the terms of the lease.
The term of the lease is equal to 75% or more of the estimated economic life of the leased asset.
The present value of the minimum lease payments is greater than or equal to 90% of die fair value of the leased asset.
IFRS, on the other hand, indicates that if the lease contract transfers "substantially all" of the major aspects of the asset from the lessor to the lessee, then the lease should be treated as a capital asset. In other words, lease accounting under IFRS is more conceptual than prescriptive.
Potential Upcoming Changes to Lease Accounting
On July 21, 2011, the International Accounting Standards Board (IASB) and the US-based Financial Accounting Standards Board (FASB) announced they would re-expose their revised proposals for a common leasing standard. This standard is being developed as a joint convergence project for IAS 17/ASC 840 (formerly FAS 13). The initial exposure draft was issued On August 17, 2010 as the Exposure Draft for Leases (ED). (FASB)
According to Financial Accounting Standards Board, if the proposals adopted, the financial reporting information available to investors about the financial effects of lease contracts will be greatly improved. The ED proposes a "right-of-use" (ROU) model to account for all leases that would be consistent under International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (U.S. GAAP), and would generally require both lessees and lessors to take a similar approach to accounting for leases. For lessee, the proposed new lease approach would bring leases which are currently considered to be operating leases, onto the balance sheet. (Standard & Poor's). The lessor transfers to lessee the right to use the lessor's asset in applying to the approach. The lessor has the right to receive payments from the lessee, and the lessee involves an obligation to make the payments to the lessor simultaneously. (FASB). The ED brings the new lease accounting standards which affect both lessees and lessors' financial statement.
Affect on Lessee's Financial Reporting
In terms of lessees, all leases are required to be capitalized on the lessee's balance sheet under the proposals. (Shawn D. Halladay 1B-7B). The capitalization contains a ROU asset and liability which representing the rental obligation. The rental obligation is recorded at the present value of the lease payments over the lease term. The lease term would be the committed lease term, plus any additional periods under renewal options that are more likely than not to be taken up. (Standard & Poor's).The ROU asset is determined at the amount of the liability to pay lease, plus any initial direct costs. Since the ROU asset is considered an intangible asset, the lessee must amortize the asset and obligation over the lease term when the asset and obligation are capitalized. In addition, by using the effective interest method, the obligation is amortized to interest and principal over the estimated lease term. (Shawn D. Halladay 1B-7B)
It is known that the operating lease is measured as operating rental expense which is "off balance sheet" under the current state. (FASB ASC, par. 840-20-25-1).Under this proposed approach, however, the volume of the balance sheets for lessees who currently have operating leases will be increased. In other words, the proposals will result in an increase in total assets and total liabilities. The reported assets would include the amortized cost value of ROU assets which would be presented within the respective category of the leased asset separately. The reported liabilities would be increased by the amortized cost value of the lease liabilities which presented separately from other financial liabilities. (Standard & Poor's). On the other hand, the proposals will affect the lessee's income statement as well. The expenses on the leases will be recorded more in early period since the cost of the lease is measured as amortization and interest expense rather than as rental expense. (Shawn D. Halladay 1B-7B). That is, operating lease rental expense would be replaced by amortization of the ROU asset and interest expense on lease liabilities. Therefore, earnings before interest, taxes, depreciation, and amortization (EBITDA), operating income, and EBIT will be improved. (Standard & Poor's). In addition, the changes in metrics may impact bonding and loan covenants, government reimbursement policies, bonus calculation, company ratings, and regulatory requirements as well. (Shawn D. Halladay 1B-7B)
Affect on Lessor's Financial Reporting
As mentioned above, under the proposed ROU approach, lessors would record an asset for the right to receive lease payments. The proposed changes replace FAS 13's lessor accounting products with two methods - performance obligation leases and derecognition leases. Lessors would apply one of two methods depending on whether they retain exposure to the significant risks or benefits associated with the leased assets. (Standard & Poor's). These two methods are as follows:
Performance obligation lease: This approach would apply if the lessor retains exposure to significant risks or benefits associated with the leased asset. Under performance obligation lease accounting, the lessor records a right to receive payments equal to the present value of the lease payments, discounted at the rate the lessor charges the lessee. The underlying leased asset remains on the balance sheet; therefore, there is no separate residual value. In addition, the lessor also records a liability equal to the right to receive payments. This liability which is another new lease accounting concept, represents deferred revenue, and would be released as the right to use the asset is provided to the lessee. In the income statement, the lessor recognizes the following items:
