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Journal entry — Leases — Boards decide on approaches for determining expense recognition pattern

Published on: Jun 14, 2012

At their joint meeting yesterday, the FASB and IASB tentatively decided on two different approaches for recognizing lease expense. The boards decided that a lessee’s and lessor’s determination of the appropriate expense recognition pattern would be based on (1) whether the lessee acquires and consumes more than an insignificant portion of the underlying asset and (2) the nature of the underlying asset.

The boards plan to discuss any remaining items related to leases at their July meeting and issue the revised exposure draft in the fourth quarter of 2012.

Lessee Expense Recognition Pattern

Constituents (mainly preparers) have consistently maintained that the pattern proposed in the boards’ respective exposure drafts (EDs) for recognizing lease expense does not reflect the economics of all types of leases. Over the past year, the boards have considered various approaches and have performed outreach to assess possible alternative expense recognition patterns. At yesterday’s meeting, the boards tentatively decided on two different approaches:

  1. A financing approach that treats the right-of-use asset as if it were purchased. The effective interest method would be used to amortize the lease liability, which is initially measured as the present value of lease payments. The asset would be amortized in the same manner as other nonfinancial assets. Interest and amortization would be presented separately in the income statement.
  2. A straight-line expense approach that results in the total lease expense being recognized on a straight-line basis. The lease liability would be measured as above. However, the amount of the asset’s amortization would simply be the difference between the interest expense and the amount calculated as the straight-line lease expense (total undiscounted lease payments divided by the lease term). The interest and amortization would not be presented separately in the income statement; rather, a single amount would be presented as the total lease expense.

How to Draw the Line

The boards tentatively decided that the “line” used to determine which approach to apply to a lease agreement would be based on whether “the lessee acquires and consumes more than an insignificant portion of the underlying asset over the lease term.” The boards’ staff papers included indicators for determining whether the lessee has met this criterion. Alternatively, the boards tentatively decided that entities could use the following practical expedient to determine the line on the basis of the type of underlying asset:1

1.     Leases of property (land or a building; or part of a building; or both) should be accounted for using the straight-line approach unless:

a.     The lease term is for the major part of the economic life of the underlying asset; or

b.     The present value of fixed lease payments accounts for substantially all of the fair value of the underlying asset.

2.     Leases of assets other than property should be accounted for using an approach similar to that proposed in the 2010 leases Exposure Draft unless:

a.     The lease term is an insignificant portion of the economic life of the underlying asset; or

b.     The present value of the fixed lease payments is insignificant relative to the fair value of the underlying asset.

Lessor Accounting

At a previous meeting, the boards had decided that lessors of investment property were exempt from applying the ED’s proposed receivable and residual lessor model and should instead apply current operating lease accounting for these leases. However, in light of their current decision acknowledging two types of leases for lessees, the boards revisited the classification of lease agreements by lessors and tentatively decided that there should be symmetry in such classification by lessors and lessees as well as in the practical expedients. Therefore, lessors will apply the receivable and residual method when they “have ‘sold’ a more than insignificant portion of the underlying asset to the lessee.”

Editor’s Note: On the basis of the boards’ discussion, it was clear they intended that the treatment of real estate leases should be different from that of all other types of leases. Generally, a lease of real estate will result in straight-line lease expense for a lessee and current operating lease accounting for a lessor. All other leases will generally be treated (1) as financing arrangements by the lessee and (2) in accordance with the proposed receivable and residual approach by the lessor.

 

 


[1] FASB’s June 13, 2012, Summary of Board Decisions.

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