What Will Lease Accounting Look Like in 2009?

ELT, Jan 2007

A refresher on the leading contenders to replace FAS 13.

The purpose of this article is to bring the reader up to date with the current thinking by national and international accounting standards-setters on proposed accounting and reporting rules to replace FAS 13. The focus of the FASB and IASB is on the so-called New Approach to Lease Accounting; what follows will summarize and analyze what they have written and discussed thus far on this subject.

The Two Approaches

FASB and IASB are working jointly on a project to change the current FAS 13 lease accounting rules in a fundamental way, moving away from the risks and rewards method that focused on the physical leased asset as the unit of accounting. They specifically state that the method is not consistent with their current conceptual framework. The new focus for lessee accounting is on the capitalization of its rights and obligations in the lease contract. The SEC estimates that $1.25 trillion in operating lease obligations are off balance sheet, which the agency considers a serious financial reporting deficiency that must be rectified as soon as possible. The lease project target for completion is 2009. Although we don't know what shape the final rule will take, we do know that FASB's intent is for lessees to capitalize material leases in some form. The two leading conceptual approaches are the Asset and Liability and Whole Asset.

The Asset and Liability method, also known as the "New Approach to Lease Accounting," generally causes the lessee to capitalize its rights and obligations in a lease, including the present value of the minimum lease payments using the lessee's incremental borrowing rate, the value of purchase and renewal options, the value of residual guarantees, etc.

The Whole Asset method causes the lessee to capitalize the leased asset at its fair market value.

FASB has expressed some sympathy for allowing immaterial leases to be exempt from capitalization by the lessee, but its prior decisions have shown that it is unlikely to give a detailed definition of "material lease," leaving it as a facts and circumstances judgment call for each lessee.

The lessor accounting under both methods is less certain. It may be to use direct finance lease accounting-that is, to record a lease receivable and a residual for all leases with income amortized at a constant rate using the lessor's implicit rate (it is possible that the after tax yield may be used to amortize earnings on tax leases). It may be to capitalize the receivable at fair value with either amortization or fair value accounting thereafter and capitalizing the residual, with periodic revaluing thereafter. It may be that revenue is recognized in relationship to how the lessor discharges its obligations under the lease. It is likely that the netting of non-recourse debt in leveraged lease accounting will be eliminated.

A Decade in the Making

The idea to change lease accounting originated in 1995 with the issuance of a paper by the G4 1, a group of national accounting standards-setters representing the U.S. (FASB), the U.K., Canada, Australia, New Zealand and a representative of the International Accounting Standards Board (IASB). The report embraced the asset and liability approach to lease accounting, a regulatory scheme dubbed "the New Approach to Lease Accounting."

Since the issuance of FAS 13 in 1976, accountants' and theoreticians' thinking on lease accounting has evolved from a risk and rewards approach, the basis for lease classification in FAS 13, to the aforementioned asset and liability, or financial components, approach. The risks and rewards approach deals with the leased asset as an asset that is either capitalized or not, depending on the risks and rewards analysis. If the lease is not a capital lease, it is an operating lease or "off-balance sheet." The asset and liability approach considers the financial components in the lease contract, including the lessee's rights and obligations, and puts the lessee's rights and obligations-not the leased asset-on balance sheet.

Inherent in this approach is FASB's current work-in-progress definition of an "asset" as "a present economic resource to which an entity has a present right or other privileged access." An asset of an entity has three essential characteristics:

1. There is an economic resource.

2. The entity has rights or other privileged access to the economic resource.

3. The economic resource and the rights or other privileged access both exist at the financial statement date.

The theory is that the right to use a leased asset should be recorded as an asset by the lessee.

FASB's current work-in-progress definition of a "liability" is "a present economic obligation of an entity." Its characteristics include the following:

1. The entity is obligated to act or perform in a certain way (or refrain from acting or performing).

2. The obligation exists at the financial statement date.

3. The obligation is economic-it is an obligation to provide economic resources to others, or to stand ready to do so.