Newsletter – July 2011

Key Highlights of 2010 Exposure Draft on Leases by FASB and IASB

Valentine Ejiogu, Director, CFO Consulting Partners

Late last year, the FASB and IASB released an exposure draft on the proposed new accounting standard, Topic 840. This will be the first significant change in lease accounting since FAS 13 was released in 1976.

If finalized, the exposure draft would converge FASB’s and IASB’s accounting for lease contracts in most significant areas. The few remaining differences pertain mostly to discrepancies with other existing standards.

Companies would face significant changes in how they account for leasing transactions if the exposure draft is adopted. For example, today if a company enters into a multi-year year lease for premises, the lease payments would normally be expensed evenly over the life of the lease. If the exposure draft is adopted, that lease would be capitalized, which would result in amortization and interest expense, with more interest expense recognized in the early years and less in the remaining years. Therefore, the Company’s income statement will suffer in the early years. Further, lease expense, which is now normally considered operating expense and which is included in EBITDA, would be shown after the EBITDA line.

Lessees would be required to perform significantly more monitoring and recordkeeping, particularly for leases currently classified as operating leases. Lessees will also need to apply lease requirements to all outstanding leases as of initial application (comparative periods would need to be restated). Lessees will need to apply the proposed transition requirements to leases currently accounted for as operating leases.
All leases are to be capitalized. That is, all leases would result in asset and liability recognition. There is no exclusion from capitalization for short-term leases; though the Boards will permit leases with a total maximum lease term of 12 months or less to be capitalized at the undiscounted value of the rents. The exposure draft proposes the lessee recognize an asset for right to use the leased asset and a liability of its obligations to make future payments and in addition, amortization of the right-to-use asset and finance expense arising from the liability.
The interest rate used for present valuing the rents and recognizing interest expense is the incremental borrowing rate, except that the “the rate the lessor charges the lessee” may be used if known. This is referred to as the implicit rate, which must now include contingent rents.

Definition of a Lease

A lease is a contract in which the right to use a specified asset (the underlying asset) is conveyed, for a period of time, in exchange for a consideration.

At the date of inception of a contract, an entity shall determine whether the contract is, or contains, a lease on the basis of the substance of the contract by assessing whether:

  • The fulfillment of the contract depends on providing a specified asset or assets (the underlying asset); and
  • The contract conveys the right to control the use of a specified asset for an agreed period of time
  • The proposed requirements would affect any entity that enters into a lease, except that they would not apply to:
  • Leases of intangible assets
  • Leases to explore for or use minerals , oil, natural gas, and similar non regenerative resources
  • Leases of biological assets
  • Certain service components of leases
  • Contracts that represent a purchase or sale of an underlying asset.

Impact on Accounting by Lessees

The following are the major differences for lessees in the new exposure draft:

  • Cash payments for leases are considered financing activities in the statement of cash flows
  • Existing operating leases will be capitalized by present valuing the remaining rents as of the date of application. Lessees will adjust the right-of -use asset for any existing deferred/prepaid rent liability or asset.
  • Similar to FAS 13, the liability is amortized using the interest method; the asset is amortized like other property, plant and equipment. Interest and depreciation expense are reported separately from other interest and depreciation, but in the same place on the income statement. Lease expenses would no longer be recognized on a straight line basis, but rather replaced by amortization and interest expense.
  • Initial direct costs are to be added to the asset to be depreciated over the life of the lease.

The exposure draft provides that lessee disclosure in the financial statements should include:

  • Description of leasing activities, including assumptions and judgments for valuing contingent rentals, sale and leaseback transactions and information about significant future leases.
  • A reconciliation of opening and closing balances for right-of-use assets and lease liabilities.
  • A maturity analysis of future rents, by year for 5 years and all remaining years combined. Minimum lease payments are to be separated from contingent rentals, termination penalties and residual guarantees.
  • Initial indirect costs incurred during the reporting period.

Impact on Accounting for Lessors

The lessor would recognize an asset representing its right to receive lease payments and, depending on its exposure to risks or benefits associated with the underlying asset, would either

  • Recognize a lease liability while continuing to recognize the underlying asset (performance obligation approach) or
  • Derecognize the rights in the underlying asset that it transfers to the lessee and continue to recognize a residual asset representing its right to the underlying asset at the end of the lease term. (Derecognition approach).

The derecognition approach is similar to the current accounting for sales-type leases under GAAP. However, the amount of the upfront profit recognized, as well as the measurement of the lease receivable and the residual asset, may be different from that recognized under the sales-type lease.

Effective Date

The Boards are yet to determine the effective date.

For questions, please contact Valentine Ejiogu at Valentine.Ejiogu@cfoconsultingpartners.com or call Valentine at (609) 309-9307, x706.