Changes Ahead - A New Lease Standard

April 29th, 2013

Changes Ahead - A New Lease Standard

           

          The main objective of financial statements is to provide faithful representation of company's position. However, there are some accounting practices, such as lease transactions, that have always been criticized by both the Financial Accounting Standard Board(FASB) and the International Accounting Standard Board (IASB). The FASB and the IASB have been working together to develop a new approach that will allow rights and obligations (assets and liabilities) to be properly represented on the balance sheet.  The boards are developing proposals after considering responses to their Discussion Paper and their 2010 Exposure Draft. The goal of this article is to provide information regarding the status of the proposed lease standard, the basic changes in lease accounting due to proposed lease standard, the likely effective date of new standard, and implementation issues.

            The FASB announced lease re-exposure on April 10th 2013. The board agreed unanimously to re-expose their revised proposal for a lease standard for a 120 day comment period.  The boards plan to issue the new proposed accounting standard by the second quarter of 2013.

            The existing lease standard requires the lessee to expense periodic rent on his or her income statement on a straight-line basis. The lessor records the periodic rental income as revenue on his or her income statement. In other words, the operational lessee only records the rent expense on the income statement and discloses future lease payments in disclosure notes.

             The boards proposed a right-of-use model for all leases, eliminating all operating leases. In other words, the proposed new lease standard requires the lessee to include all long-term leases initially on the balance sheet. The lessee would measure the lease liability based on the present value of the lease payment over the period, using discount rate at the lease inception. The lessees must classify their leases into two categories: insignificant or significant portion of the leased asset to be consumes. For leases that require the lessee to own an insignificant portion of the leased asset, such as land or a building, the lessee must categorize the lease as a straight-line basis. Under straight-line basis, the lessees would recognize lease expense on a straight-line basis. For leases that require the lessee to own a significant portion of the leased asset, such as equipment, the lessee must recognize an interest expense or an amortization expense. Thus, the proposed new standard will affect both the income statement and the balance sheet.

            Under the proposed lease standard, lessors must classify  leases into two categories: operating lease accounting or the receivable and residual approach. The lessor will use the operating lease accounting if the lessee uses an insignificant of the lease asset. However, if the lessee uses a significant portion of the leased asset, then the lessor will use the receivable and residual approach. With the receivable and residual approach, the lessor “sells” part of the lease asset to the lessee, and the lessor classifies the “sold” asset as receivable. The lessor will record the unsold portion of the asset as residual. With this approach, the lessor must recognize profits and losses upfront on the portion that is “sold.” This means that the residual amount will be deferred profit and a part of the carrying value.

            The implementation of the proposed new lease standard may be difficult for companies. The proposed new standard will affect the decision making process for lessees. The lessee may consider buying the asset, instead of leasing it. The cost of upgrading software, training employees, and hiring experts to train may be an additional cost for companies. The lessee could violate the debt covenants due to the increase in liabilities. This violation may cause the agency problems. 

            The goal of financial statements is to provide a faithful representation of a company's financial position. The information provided in the financial statements should be transparent. The proposed new lease standard seems to address the user’s need for transparency.