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Financial Reporting - Accounting for Leases

The FASB and IASB jointly issued their initial exposure draft on accounting for leases in August 2010.  Based on significant concerns raised in comment letters about the proposed accounting guidance, the Boards began redeliberations in January 2011 and announced that they were substantially completed in July 2012.  A revised exposure draft with a 120-day comment period is planned for the end of November 2012.

The revised ED will retain the “right of use” concept in the original ED, requiring lessees to reflect all leases on the balance sheet, with the exception of short-term (less than 12-month) leases.  However, the Boards decided there should be a distinction in the expense recognition pattern depending on the level of consumption of the asset. A practical expedient will apply based on the nature of the underlying asset, and is further outlined in the following paragraphs.

Lessee Accounting
As applied to lessee accounting, it is presumed that the lease of real property (land, building, or part of a building) does not substantially “consume” the value of the property, and should be accounted for by using a straight-line expense recognition pattern.  If, however, the lease term is for the major part of the real property’s economic life, or the present value of the fixed lease payments accounts for substantially all the property’s fair value, then the lessee will use the “interest and amortization” approach, which tends to front-load the expense.

Conversely, for leases of equipment, it is presumed that the lease substantially “consumes” the asset, and should be accounted for using the “interest and amortization” approach.  If, however, the lease term is for an insignificant portion of the asset’s economic life, or the present value of the fixed lease payments is an insignificant portion of the fair value of the asset, then the expense will be accounted for on a straight-line basis.

Lessor Accounting
Similar to lessee accounting, the Boards are proposing two types of accounting for lessors, based on the same underlying consumption concept with practical expedients.  If the lease does not grant the lessee the right to consume more than an insignificant portion of the underlying asset (presumed for leases of real property):

  • The underlying asset remains on the balance sheet of the lessor,
  • No lease receivable or gain or loss is recognized at the start of the lease, and
  • Rental income is recognized on a straight-line basis.

Conversely, if the lease grants the lessee the right to consume more than an insignificant portion of the underlying asset (presumed for machinery and equipment), the lessor applies the “receivable and residual” approach and:

  • Derecognizes the entire carrying amount of the asset;
  • Recognizes a receivable, measured as the present value of the lease payments discounted at the rate implied in the lease; and
  • Recognizes a residual asset, measured by allocation of the carrying amount of the underlying asset.

Lease Term
The lease term is the noncancelable period for which the lessee has contracted to lease the underlying asset.  The lease term also includes any options to extend the lease when there is a significant economic incentive to exercise the option, such as a bargain renewal, or a significant economic disincentive to not exercise the option, such as termination penalties.

Variable Payments
The measurement of lease assets and liabilities includes lease payments that are structured as variable payments but are in substance fixed payments, dependent on an index or rate, or expected to be payable under residual value guarantees.  However, variable payments that are based on usage or performance, such as those for retail facilities tied to a percentage of revenue, will not be included.

 

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