Lease Accounting Changes to Impact Financial Reporting

Lease Accounting Changes to Impact Financial Reporting

by Barbara Apostolou - Professor, University of West Virginia, Nicholas Apostolou - Visiting Professor, University of West Virginia, and Jack W. Dorminey - Assistant Professor, University of West Virginia

On August 17, 2010, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) jointly released exposure drafts (ED) of proposed accounting standards that, as currently written, significantly change lease accounting. Under the proposed model, lessees have only one accounting treatment permitted for all leases. Currently, a lessee may treat a lease as an operating lease or a capitalized lease. The only financial statement effect of an operating lease is that the lease payments are reported as rental expense on the income statement. Conversely, a capitalized lease requires that an asset and a liability be recorded on the balance sheet. As a result, most lease agreements are purposefully structured in a way that avoids the capitalized treatment.

The effect of the ED is to remove the treatment option and require that all leases be recorded as capitalized leases by the lessee, thus requiring firms to show all lease liabilities on the balance sheet. PwC and Rotterdam University in the Netherlands studied 3,000 companies worldwide and estimated that the reported interest-bearing debt of these companies will increase on average by 58 percent as a result of the new accounting treatment. This change will dramatically impact financial metrics of energy companies because they lease significant industrial equipment, autos, office space, and even specialty printers and copiers.

While the FASB and IASB have not yet set an effective date, implementation is not expected any earlier than 2014. The proposal has generated a great deal of controversy. The FASB received 781 comment letters, with the majority critical of the new model. The rules are complicated and the impact on corporate financial statements will be significant.


Proposed Lessor Accounting Rules


The ED proposes two models for lessors, depending on the terms of the lease and the effect on the lessor. The first is the performance obligation approach, which recognizes the lessor?s risks or benefits. The second is the derecognition approach, which is used when the lessor has minimal risk exposure...

The performance obligation approach is used when the lessor retains exposure to significant risks or benefits associated with the leased asset. Under this approach, the lessor continues to recognize the underlying leased asset on the balance sheet as well as a lease receivable. The accounting treatment by the lessor is symmetrical to that used by the lessee.

A lessor using the performance obligation approach would also recognize the following items in the income statement:

  1. Interest income on the right to receive lease payments.
  2. Lease income as the lease liability is satisfied.
  3. Chanes to the lease liability due to changes in expec tations of contingent rentals or payments associated with term option penalties and residual value guarantees, to the extent that the lessor has satisified the related lease liability.
  4. Impairment losses on the right to receive lease payments.


Derecognition Approach

A lessor would apply the derecognition approach when it is not exposed to significant risks or benefits associated with the leased asset. In essence the lessor "sells" a portion of the leased asset, recognizes profit or loss, and derecognizes the leased asset.The remaining portion of the carrying amount of the underlying asset not considered ?sold? is reclassified as a residual asset.Under existing standards, the entire underlying asset is derecognized for a finance (capital) lease.

If using the derecognition approach, a lessor would also recognize the following items in the income statement:

  1. Lease income representing the present value of the lease payments and lease expense representing the cost of the derecognized portion of the underlying asset.
  2. Interest income on the right to receive lease payments.
  3. Lease income and lease expense upon any reassessment of the lease term.
  4. Changes in the right to receive lease payments resulting from changes in the expected amount of contingent rentals and expected payments under term option penalties and residual value guarantees.
  5. Any impairment losses on the right to receive lease payments or on the residual asset.



The proposal introduces complexity into a system that has been used for decades in the U.S. The volume of lease transactions in the U.S. alone exceeds a trillion dollars, with the vast majority of lease liabilities not recognized on any balance sheet. The FASB and IASB released in August of 2010 a joint exposure draft that will dramatically change accounting guidance for both lessees and lessors by requiring balance sheet recognition of all leases... 

The proposed requirement to recognize additional assets, liabilities, and generally accelerate the recognition of expense will likely affect key performance ratios used in credit and investment decisions. Although the effective date for the final standard is expected for 2014, energy companies should prepare for the impact on their financial metrics, business processes, debt structuring, tax strategy, and information systems.

Information referenced herein is provided for educational purposes only. For legal advice applicable to the facts of your particular situation, you should obtain the services of a qualified attorney licensed to practice law in your state.

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