On August 17, 2010 an exposure draft was jointly released by the IASB and FASB to create more uniform reporting for leases. The current lease system allows for two lease categories. A Capital lease according to US GAAP or a Finance lease according to IFRS recognizes a lease on the balance sheet as both a liability and an asset. However for both IASB and FASB, an operating lease has no effect on the balance sheet. An operating lease simply expenses the lease throughout the life of the lease. As a result of an operating lease, assets and liabilities are understated and leverage ratios are inaccurate. Investors are forced to make estimates when calculating leverage ratios which greatly reduce comparability between financial statements. The exposure draft aims to increase comparability of financial statements through a principles based approach.
Lessee Accounting
The exposure draft proposes a new uniform way to account for leases in order to increase comparability. Assets and liabilities will show up on the balance sheet for all leases under the new system. The lessee will initially recognize a right-of-use-asset and an obligation to make lease payments. This asset and liability will be recorded at the present value of the lease payments and any other contingent payments. In order to calculate the present value three items are necessary, the discount rate, the lease term, and the lease payments. The present value should be calculated using the lessee's borrowing rate or the rate charged by the lessor. The term of the lease payments will be for the expected term of the lease contract instead of the minimum term. The expected term of the lease contract is defined as the longest possible term that is more likely than not to occur. This means the longest term that is more than 50% possible should be accounted for. Under current standards possible future renewals do not need to be accounted for.
Example: Calculate Expected Term
A lease term of 7 years would be used because it s the longest term that is more likely than not to occur.
No Renewal
2 Year Renewal
5 Year Renewal
Lease Term
5 Years
7 Years
10 Years
Probability
10%
60%
30%
Collective Probability
100%
70%
30%
The lease payments will be defined in the contract as whether they are consistent or contingent upon a variable, such as sales. If there are contingent rental payments then they will need to be estimated for the term of the lease. In this case they should be estimated for 7 years because that is the more likely than not term of the lease. After finding the expected contingent rent payment, the right-of-use asset can be calculated. The right-of-use asset is calculated by adding the present value of the lease payments and the expected contingent rental payment.
Example: Estimate Lease Payment
5% Revenue Decline
Constant Revenue
5% Revenue Growth
Total
Sales for 7 Years
6,033,254
7,000,000
8,142,008
Contingent Rentals
(Assume 2%)
120,665
140,000
162,840
Present Value
(Assume 6% discount rate)
80,249
93,108
108,298
Probability
25%
50%
25%
Estimated
20,062
46,554
27,075
93,691
Under the exposure draft's proposal when a lease payment is made, the journal entries will resemble the effective interest method. Interest expense will be debited by the effective interest rate multiplied by the carrying value of the lease liability. The lease liability will be debited by the difference between the lease payment and interest expense. Amortization expense will be debited, the lessee can amortize by any reasonable method as long as they consistently use the same method throughout the term of the lease. Any additional expense to the estimated lease payment that arises from contingent obligations will be debited. Cash will be credited for the amount of the lease payment and the right-of-use-asset will be credited for the amount amortized. These are the typical journal entries that will be recorded on the lessee's books at the time of a lease payment.
Example: Lessee Journal Entry
At Start of the Lease
Debit
Credit
Right-of-use Asset
Xxx
Lease Liability
xxx
At First Payment of the Lease
Debit
Credit
Lease Liability
Xxx
Interest Expense
Xxx
Amortization Expense
Xxx
Additional (contingent) Expense
Xxx
Cash
xxx
Right-of-use-Asset
xxx
As a result of these proposed journal entries the financial statements will represent leases much differently then they currently do. Currently all that would show in the lessee's income statement is rent payment expense and potentially an expense for contingent rentals. The proposed method would result in amortization expense, interest expense, and potentially an expense for contingent rentals.
Example: Effect on Income Statement
Income Statement
Proposed
Current
Amortization Expense
xxx
Interest Expense
xxx
Contingent Rentals
xxx
xxx
Rent Payment
xxx
Total
xxx
xxx
Lessor Accounting
Under the new proposal lessors will have to apply one of two models for leases. These two models will be the performance obligation approach or the derecognition approach. The model used should be determined at the start of the lease and not change during the lease. The distinction between which model to use depends on the risk still involved for the lessor. A lessor that maintains significant risk or benefits related to the underlying asset will use the performance obligation approach. Significant risk or benefit would exist if the leased item is expected to have enough value to be sold or leased again. If a lessor does not maintain significant risk or benefit associated with the underlying asset then the derecognition approach will be applied.
Performance Obligation Lease
At the commencement of a performance obligation lease, the lessor will need to recognize an asset for the right to receive lease payments. This asset would be equal to the present value of the future lease payments in addition to any start up costs the lessor faces. Because of the inclusion of start up costs and other potential variants, this asset will not necessarily be equal to the Lessee's liability. The lessor may use a different interest rate then the lessee to discount future cash flows. Also, the lessor may not include all possible future contingent lease payments because of unreliable estimations. The lessor could estimate a different life for the lease because the information available about renewals will most likely be different for the lessor then for the lessee.
The lease term used to calculate the present value of the lease payment receivable would be the longest term more likely than not to occur. This term would be calculated the same way as the previous example for the lessee. Unlike the lessee's accounting, residual and contingent payments should only be included if they can be calculated reliably. This is in hope of underestimating the receivable instead of overestimating the future payments. Term option penalties should also be included in this calculation of the receivable. The receivable asset should be accounted for at amortized based on the use of the asset by the lessee. A straight line amortization method should be used if the lessor cannot reasonably estimate the rate of use by the lessee.
A performance obligation liability must also be recorded by the lessor to offset the asset being leased. This liability is initially set at the present value of estimated future lease payments. The lease liability should be amortized according to an appropriate method, such as by units or a straight-line method.
The carrying amount of the receivable would need to be reassessed every reporting period. If any significant change in estimated future lease payments is evident then the proper impairment needs to be applied. Changes in the estimated lease receivable would need to be recognized on the income statement.
Derecognition Approach
Under the derecognition approach a lessor must remove part of the underlying leased asset and recognize a new asset. This new asset is for the right to receive lease payments. The residual value from the underlying asset will remain on the books as a residual asset. The right to receive asset would be calculated by finding the present value of the future lease payments. The portion of the asset to derecognize would be calculated by dividing the present value of the lease payments by the fair value of the underlying asset then multiplying by the carrying amount of the underlying asset. The amount left to allocate to the residual asset would be the carrying amount minus the derecognition amount. The interest income for the derecognition approach would be calculated using the effective interest method.
Example: Calculate Derecognized Amount
Given
Carrying Amount
50,000
Fair Value
55,000
Annual Lease Payments
12,000
Length of Lease (years)
5
Rate
10.42%
PV of Lease Payments
45,000
Calculated
Derecognized Amount
40,909
Allocated to Residual Asset
9,091
Example: Recognition of Lease Payments
Years
1
2
3
4
5
Total
Revenue
45,000
0
0
0
0
45,000
Cost of Sales
(40,909)
0
0
0
0
(40,909)
Interest Income
4,689
3,927
3,086
2,157
1,132
14,991
Profit
8,780
3,927
3,086
2,157
1,132
19,082
An immediate profit is recognized at the commencement of the lease for the difference between the receivable and the amount derecognized. The lease payments to be received would be reported apart from other financial assets. Also, the residual asset would be reported separately, but with other PP&E. The expected lease payments should be reassessed each reporting period if there are any new significant details that may affect future lease payments.
Subleases
In the case of a sublease one entity may act as a lessee and lessor. The entity should still follow the standard to account for the original lease as a lessee. This entity should also follow the performance obligation approach to account for the sublease as a lessor. The sublessor would separate the lease liability arising from the original lease from other liabilities. A net lease asset or liability would be reported from the combination of the sublessors lease liability and receivable. The sublessee would simply account for the sublease using the right-of-use approach.
Disclosures
The exposure draft requires more in depth disclosures about lease arrangements then the current standard. The amounts of each lease will need to be identified and explained. The affect leases may have on the timing of cash flows must also be reported. Items such as the terms of renewals, contingencies, residual values, and discount rates used need to be disclosed.
Conclusion
The exposure draft should allow the financial statements of entities to better represent the underlying transaction. This is accomplished mainly by placing assets and liabilities arising from leases on the balance sheet for all leases. However, the exposure draft relies heavily on judgments and estimations. This exposure draft will ultimately reform the accounting for leases by transitioning the accounting for leases from a rule based approach to a principles based approach.
