Lease Accounting
The pending changes in lease accounting have been a hot topic item since 2009, when the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) issued a discussions paper for public comment. Since then, we have seen two exposure drafts, the first issued in August 2010 and the most recent issued in May 2013. Although the final guidance is not yet known, it is important to understand the exposure draft and begin planning in order to make educated decisions for the future of your company.
Lease treatment
The 2013 exposure draft contains a dual lease model. Each lease must be evaluated and classified as a
“Type A” or “Type B” lease. Classification of these leases is based on whether the lessee consumes a more than insignificant portion of the underlying asset, as described below. Lease classification should not be reassessed after the commencement of the lease.
• Type A - under current guidance, similar to a capital lease (i.e., restaurant equipment lease) o If the lease represents an asset that is not property (equipment, cars, trucks), then it
should be classified as a Type A lease unless the terms of the lease meet one of the two following criteria:
Economic life test: if the lease term represents an insignificant part of the total economic life of the asset
Present value test: if the present value of total lease payments is insignificant compared to the fair value of the asset
If the asset is not property, but meets one of the criteria above, the asset should be classified as a Type B lease.
• Type B - under current guidance, similar to an operating lease (i.e., restaurant building lease) o If the lease represents an asset that is property (land, buildings), it should be classified
as a Type B lease, unless the terms of the lease meet one of the two following criteria:
Economic life test: if the lease term represents a significant part of the total economic life of the asset
Present value test: if the present value of total lease payments is substantially all of the fair value of the asset
If the asset is property, but meets one of the criteria above, the asset should be classified as a Type A lease.
Short term leases, defined as a lease term of one year or less, are to be accounted for under the same operating lease method that currently exists.
Discount rates are calculated based on the information available at the commencement date of the
lease. Discount rates should reflect the rate the lessor charges the lessee as described in the terms of
the agreement. If the rate is not explicitly stated, the lessee should use their incremental borrowing
rate. (Note: Non-public entities are permitted to use a risk-free discount rate as an accounting policy
election for all leases).
With the elimination of build-to-suit considerations from the proposed guidance, the lessee will no longer be required to consider and then possibly recognize the leased asset as if it were the legal owner during the construction period. This means that leased assets and liabilities will not be recognized until lease commencement when construction is complete. The elimination of build to suit accounting would also affect measurement of the asset and liability during the lease term since the right-of-use asset and lease liability will be measured as a lease rather than as an owned asset with a mortgage.
Impact on financial reporting Type A lease
1. Record the initial measurement of the lease:
DR: Right of use asset – Lease asset should represent the initial measurement of the lease liability plus any lease payments made prior to the commencement date (less any lease incentives received), and any initial direct costs incurred by the lessee.
CR: Lease liability – Lease liability should represent:
the present value of the fixed and variable payments, less any lease incentives received from the lessor
amounts expected to be payable under residual value guarantees
exercise price of a purchase option if the lessee has a significant economic incentive option
payments for penalties for terminating the lease if the lease term reflects the lessee exercising an option to terminate the lease.
NOTE: per the current proposal, lessees that have variable lease payments dependent on an index or rate must measure using the index or rate at commencement of the lease, and reevaluate each year.
2. Record the cash payment, and expense each period (two journal entries):
o DR: Lease liability DR: Interest Expense CR: Cash
o DR: Amortization expense – to be recognized on a straight-line basis over the life of the lease
CR: Right of use asset (i.e., accumulated amortization)
The interest expense and amortization expense is effectively your rent expense; however, the expense is
higher in the first half of the term as interest is recognized on the effective interest method.
Type B lease
1. Record the initial measurement of the lease:
DR: Right of use asset – Lease asset should represent the initial measurement of the lease liability plus any lease payments made prior to the commencement date (less any lease incentives received), and any initial direct costs incurred by the lessee.
CR: Lease liability – Lease liability should represent:
the present value of the fixed and variable payments, less any lease incentives receivable from the lessor).
the present value of the fixed and variable payments, less any lease incentives received from the lessor
amounts expected to be payable under residual value guarantees
exercise price of a purchase option if the lessee has a significant economic incentive option
payments for penalties for terminating the lease if the lease term reflects the lessee exercising an option to terminate the lease.
NOTE: per the current proposal, lessees that have variable lease payments dependent on an index or rate must measure using the index or rate at commencement of the lease, and reevaluate each year.
2. Record the cash payment, and expense each period (two journal entries):
o DR: Lease liability CR: Cash
o DR: Lease expense – to be recognized on a straight-line basis CR: Lease liability
CR: Right of use asset (i.e., accumulated amortization)
As noted above, the primary difference between the Type A and Type B lease is that Type A requires recognition of the unwinding of the lease liability to be recognized separately from the amortization of the right of use assets, whereas Type B combines the unwinding of the lease liability with the amortization of the right of use asset on a straight-lined basis. Effectively, Type B leases will have a lower expense impact per year in the first half of the lease agreement and a higher impact on expense in the second half when compared to Type A.
Leases that are currently being accounted for as operating leases are not “grandfathered” under the old
guidance. Lessees must select to implement the guidance on the full retrospective approach or the
modified retrospective approach. The full retrospective approach would require the lessee to go back to
the lease commencement date to measure the lease assets and liabilities and apply the guidance each
year until the current year. The modified retrospective approach allows the lessee to use information
available at the date of transition versus the commencement date to measure the lease assets and
liabilities.
Disclosures Balance Sheet
A lessee should present the right of use asset and the lease liability separately on the balance sheet from the other assets and liabilities recorded, as well as right of use assets and lease liabilities deriving from Type A and Type B leases separately. If these assets are not separately stated on the balance sheet, they must be included within the same line as other assets and liabilities, as if they were owned, and a disclosure note must state where on the balance sheet these items are included.
Income Statement
• Type A leases – present the unwinding of the discount (i.e., interest expense) on the lease liability separately from the amortization of the right of use asset.
• Type B leases – present the unwinding of the discount on the lease liability with the amortization of the right of use asset as “lease expense”.
Statement of cash flows
• Type A leases – repayments of the “principal” portion of the lease liability should be categorized with financing activities.
• Type B leases – lease payments should be classified in operating activities Notes to the financial statements
The 2013 Exposure draft requires a number of additional disclosures. Notes to financial statements should include disclosures such as:
• Description of the leases, the basis, terms, and conditions of how variable lease payments are determined
• Narrative disclosure of the options that are included as part of the right of use asset and lease liability, including options that are not used
• Listing of guarantees
• Restrictions or covenants contained within the lease agreements
• Description of information that requires significant assumptions and judgment (i.e., discount rates, contract allocations between lease and non-lease components)
• Details on leases that have yet to commence, but create significant obligations for the lessee
• Reconciliation between the opening and closing balances of the lease liabilities, detailing out the unwinding of the discount and any other items that caused the balance to change (Type A and Type B must be reconciled separately) (note: this disclosure is not required for nonpublic entities).
• Variable lease payments that are recognized during the period but not included in the lease liability (i.e., percentage rent)
• Maturity schedule
• Listing of related party transactions
• If IFRS is being applied, a reconciliation of right of use assets should also be disclosed
Be prepared
While the changes are not yet finalized or in effect, it may be inevitable that change is coming. The following steps can help you stay ahead of the curve.
• Stay informed. Know the recent changes to the accounting guidance and discuss potential issues early on with both the management of the company as well as your CPA firm.
• When lease renewals arise, discuss the potential impact that a long renewal term vs. shorter renewal term may have on your financial statements (i.e., signing a 20 year lease vs. 10 year lease will increase your liabilities substantially and will affect the determination of the type of lease you are obtaining).
• Review all leases to summarize pertinent information from each lease to aid in the transition once guidance is finalized (i.e., terms, renewal options, payment schedules).
• Review all contracts to determine if the accounting treatment may change (for example, a two year operating lease for a copy machine may now fall under a different accounting treatment).
• Be aware of how the new guidance will alter your bank covenant ratios (i.e., debt to equity ratio, debt service ratio). Discuss with your banker what changes the bank may make on covenants.
• Understand how the proposed changes may impact your taxes. While the proposed changes are
not expected to impact federal taxes, the classification changes on the balance sheet and
income statement could affect state and local tax apportionment as well as personal property
taxes.
What is the lease term per the lease
agreement?
Less than one year
No change in accounting procedures. Lease should be accounted
for as an operating lease.
Greater than one year Is the leased asset property (e.g., land,
building)?
Does the lease term represent an insignificant part of the total
economic life of the asset OR is the present value of the total
lease payments insignificant compared to the fair value of
the asset?
Does the lease term represent a significant part of the total economic life of the asset OR is the present value of the total lease payments substantially all
of the fair value of the asset?
Type A Lease*
Type B Lease*
YES
NO
NO
YES
NO YES
*Refer to lease accounting write up for additional information and accounting guidelines for each lease type.
