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Heads Up on leases proposals

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18 Aug 2010

Deloitte (United States) has published a new Heads Up newsletter discussing the exposure draft (ED) Leases, issued by the FASB and IASB. The ED, released by the FASB as a proposed Accounting Standards Update (ASU), creates a new accounting model for both lessees and lessors and eliminates the concept of operating leases. The proposed ASU, if finalised, would converge the FASB's and IASB's accounting for lease contracts in most significant areas.

The table below, reproduced from the newsletter, highlights the most significant provisions of the proposed lease accounting model:

Lessees

  • Lessees will recognize a right-of-use asset and a liability for their obligation to make lease payments for all leases. "Off-balance-sheet" leases and the concept of "lease classification" in the current accounting model will no longer exist for lessees.
  • For leases previously classified as operating leases, rent expense will be replaced with amortization expense and interest expense. Amortization of the right-of-use asset will generally be on a straight-line basis; however, interest expense will be front-end loaded (i.e., like interest on an amortizing mortgage).
  • Under an expected-outcome approach, the lessee recognizes contingent rentals and residual value guarantees as part of the lease liability. The lessee bases its inclusion of rentals for renewal periods in the lease liability on the longest possible term that is more likely than not to occur.
  • Unlike the current lease accounting model, the new model requires an assessment of whether there are new facts and circumstances that would significantly change the lessee's estimate of contingent rents and renewal periods as of each reporting period.
  • The identification of nonlease components (e.g., maintenance costs in certain arrangements) will become more important under the new model.
  • Total lease-related expense will be front-end loaded, unlike current operating lease treatment. Rising asset prices, or a lessee entering into an increased number of new leases, could result in net income remaining lower than the amount that would be achieved under current operating lease accounting – even as old leases expire.
  • Because rental expense is not recorded under the new model, EBITDA will be higher than it is under current operating lease accounting.
  • Lease payments will be treated as financing cash outflows in the statement of cash flows. Under current U.S. GAAP, operating lease rent payments are treated as an operating cash flow.

Lessors

  • The proposed ASU includes two accounting models for lessors. A lessor that retains exposure to significant risks or benefits associated with the underlying asset would apply the performance obligation approach; otherwise, the lessor would apply the derecognition approach.
  • Under the performance obligation approach, the leased asset remains on the lessor's books. The lessor records (1) a receivable for the expected lease payments and (2) a corresponding performance obligation liability (essentially, deferred revenue).
  • Under the derecognition approach, a portion of the leased asset is removed from the lessor's books. The lessor records (1) a receivable (and income) for the expected lease payments and (2) a residual asset representing the right to the underlying asset at the end of the lease term. Expense would be recognized for the portion of the leased asset that is removed from the lessor's books. Income and expense may be presented net depending on the lessor's business model.
  • The FASB has a separate project to consider whether owners of investment properties (e.g., certain lessors of real estate) should be required to record those properties at fair value.

Business Consequences

  • An increase in assets and liabilities could result in lower asset turnover ratios, lower return on capital, and an increase in debt-to-equity ratios. This could affect borrowing capacity or compliance with loan covenants.
  • The elimination of "off-balance-sheet" financing eliminates one of the advantages of leasing for lessees. This could result in a push toward shorter term leases or buying an asset rather than leasing it. Lessees would need to balance this consideration with potentially higher rents for shorter-term leases as well as reduced amortization periods for leasehold improvements (which would generally result from a shorter lease term). In addition, the other benefits of leasing – flexibility to change locations or equipment, reduced property management responsibilities, potential for financing 100 percent of the asset cost, improved cash flows, etc. – remain unchanged.
  • Accounting systems will most likely need to be enhanced or updated to address the new standard – lease contract management systems will need to be more closely integrated with lease accounting systems.
  • The new model will result in additional temporary differences for income tax accounting purposes. In addition, state and local taxes will be affected when the computation (or impact) of taxes is based on U.S. GAAP amounts.

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