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SEC Insights - September 2010

 

Accounting for Leases

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Background Information

The way companies account for leases may significantly change in the future. The International Accounting Standards Board (“IASB”) and the Financial Accounting Standards Board (“FASB”) have been working on several joint projects aimed at improving existing accounting standards and continuing to converge standards between the IASB and FASB. Revamping accounting for leases has been one of the more publicized projects because there are many in the financial community that believe the current rules do not accurately provide a faithful representation of the leasing transaction. The proposed rules will affect both lessees and lessors and will significantly impact the financial statements. Final standards are expected in 2011 with an effective date expected in 2013.

Lessees

One of the major criticisms of lease accounting related to the lessee is that the lease obligation does not get recorded on the balance sheet when a company enters into an operating lease. Under the proposed rules all leasing transactions will be recorded similar to how a capital lease gets recorded under the current rules (i.e. record an asset and a liability). Here is how it works under the proposed rules. At the date of commencement of a leasing transaction (the commence date is the date the lessor makes the underlying asset available for use by the lessee), the lessee records on the balance sheet a “right-of-use” asset and a liability to make lease payments.

The liability to make lease payments will be recorded at the present value of the lessee lease payments. In determining the present value the lessee should use the rate of interest at the inception date of the lease, the lessee would have to pay to borrow money over similar terms to purchase the asset (“Incremental Borrowing Rate”). If the Incremental Borrowing Rate is not determinable than the lessee should use the rate the lessor charges the lessee. In addition, the lessee will also need to determine the lease term and/or contingent rental payments. Some leases include options to either terminate or extend the lease term. The proposed rules require the lessee to determine longest possible lease term that is more than likely than not to occur (50% threshold). In additions some leases include contingent rental payments. These contingent payments should be estimated in determining the present value of the liability to make lease payments. The “right-to use” asset gets recorded at the amount of the liability to make lease payments plus any initial direct cost (i.e. legal fees related to the lease, commissions, preparing and processing leasing documents, closing the transaction).

Subsequent to the commencement of the lease, the lessee adjusts the liability to make lease payments for payments made and records the liability at amortized cost using the effective interest method. In addition, the right-to –use asset should be amortized over the lesser of the lease term or asset life. As a result, the lessee will record interest expense on the liability to make lease payments and amortization expense on the "right-to-use" asset as opposed to rent expense under the current rules.

The lessee is also required to reassess the carrying amount of the liability to make lease payments at each reporting period if facts and circumstances indicate there could be changes to either the term expected, contingent rental amounts or any changes to expected payment resulting from term option penalties or residual value guarantees. An adjustment to the liability to make lease payments as a result of a change in the lease term would also result in an adjustment to the “right-of- use” asset. Adjustments to expected contingent rental amounts, payment resulting from term option penalties or residual value guarantees should be adjusted (1) in the profit or loss if they relate to changes in the current or prior period of (2) as an adjustment to the “right-of- use” asset if the changes relate to future periods.

Lessor – Two Approaches

Under the proposed rules a lessor will need to determine which approach it will need to use at the inception date of a lease: the performance obligation approach or the derecognition approach. The determination is made based on whether the lessor retains exposure to significant risks or benefits associated with the asset being leased. If the lessor retains the risks or benefit then the performance obligation approach should be utilized. If the lessor does not retain the risks or benefit then the derecognition approach should be utilized.

Performance Obligation Approach

The Performance Obligation Approach is symmetrical to the way a lessee records a lease under the proposed rules. At the date of commencement the lessor records an asset on the balance sheet for its right to receive lease payments and a lease liability (the lessors obligation to permit the lessee to lease an asset over a lease term). In addition the lessor should derecognize the underlying asset being leased. Similar to the lessee’s liability to make lease payments, the lessor records the right to receive lease payments at the sum of the present value of the lease payments discounted by the rate the lessor charges the lessee and any initial direct costs. Like the lessee, the lessor should determine the lease term and/or contingent rental payments. The same consideration mentioned above for the lessee should be considered by the lessor (i.e. longest possible lease term taking into consideration of renewal terms that are more likely than not to occur and contingent rentals). The lease liability is recorded at the amount of the right to receive lease payments.

Subsequent to commencement of the lease, any payments received by the lessee will reduce the right to receive lease payments. The lessor will also record the right to receive lease payments at amortized cost using the effective interest rate method (similar the lessee accounting for the liability to make lease payments). The lease liability should be reduced based on a pattern of use of the underlying asset into revenue. If the lessor cannot determine a rational and systematic manner for the basis of use then, a straight line method should be used.

At each reporting period the lessor is required to reassess the carrying amount of the right to receive lease payments to determine if there are any significant changes to either the term, expected contingent rental amounts or any changes to expected payment resulting from term option penalties or residual value guarantees (similar to the assessment the a lessee has to do related to the liability to make lease payments). An adjustment to the asset to receive lease payments as a result of a change in the lease term would also result in an adjustment to the lease liability. Adjustments to expected contingent rental amounts, payment resulting from term option penalties or residual value guarantees should be adjusted (1) in the profit or loss to the extent that the lessor has satisfied the related lease liability (2) or as an adjustment to the lease liability to the extent the lessor has not satisfied the related lease liability although the lessor is excluded from making an adjustment that would reduce the lease liability to below zero.

Derecognition Approach

A lessor should use the Derecognition Approach when it does not retain exposure to significant risks or benefits associated with the asset being leased. Under the Derecognition Approach, at the commencement of the lease the lessor records as an asset, the right to receive lease payments at the sum of the present value of the lease payments discounted using the rate the lessor charges the lessee and any additional direct costs incurred by the lessor (same as the Performance Obligation Approach). The same considerations for recording present value apply in the Derecognition Approach that apply in the Performance Obligation Approach (i.e. option renewal terms and contingent rentals.) The lessor also derecognizes from the balance sheet the carrying amount of the asset being leased (which represents the lessee right to use of the underlying asset) and reclassifies a residual asset which represents the carrying amount of the leased assets that the lessors retains rights in.

The amount of the leased asset that is derecognized and the initial amount that is recorded as the residual asset is determined by allocation the carrying amount of the leased asset at the inception date of the lease in proportion to the fair value of the rights that have been transferred and the fair value of the rights that have been retained by the lessor.

As a result of the above, on the commencement date the lessor will record lease income representing the present value of the lease payments and lease expense representing the portion of the leased asset that is derecognized by the lessor on the commencement date. Subsequent to the commencement date, any payments received by the lessee will reduce the right to receive lease payments. The lessor will also record the right to receive lease payments at amortized cost using the effective interest rate method (similar to the Performance Obligation Approach).

Similar to the Performance Obligation Approach, at each reporting period the lessor is required to reassess the carrying amount of the right to receive lease payments to determine if there are any significant changes to either the term, expected contingent rental amounts or any changes to expected payment resulting from term option penalties or residual value guarantees.An adjustment to the asset to receive lease payments as a result of a change in the lease term would also result in the lessor allocating the change to the rights derecognized and the residual asset . Adjustments to expected contingent rental amounts, payment resulting from term option penalties or residual value guarantees should be adjusted to present value of the right to receive lease payments and to the profit or loss.

Conclusions and Impacts

It is important companies understand the impact these proposed rules will have on their financial statements when they go final. Under the transition rules for the proposed guidance all outstanding leases on the effective date would be subject to the new accounting treatment. Grandfathering of existing leases will not be permitted. In addition, if prior year’s financial statements are presented for comparative purposes, companies will need to apply these new rules to the earliest period presented using a simplified retrospective approach. As such companies with financial covenants should begin to determine what if any impact these new rules will have on their covenants at the effective date. Companies may need to speak to their lenders to re-negotiate their financial covenants.

Some in the financial community believe that the new rules will have an impact when companies negotiate leases. Because lessee s will now be required to record an asset and liability on their financial statements some lessees may be motivated to enter into shorter termed leases. In addition renewal options may be less frequent in leases because under the new rules if it is more likely than not that the lessee will exercise the renewal option the lessee would be required to record a larger liability. In addition, some lessors may be motivated to offer better terms on longer term leases to motivate lessee’s to enter into longer leases.

The financial statement and financial ratios will also be impacted significantly for lessees. Since the lessee will be required to record a right to use asset and the liability, their leverage ratio and capital ratios will be negatively impacted. Although there will be minimal effect on companies net worth. In addition, since rent expense will now be recorded as interest expense and depreciation expense, company’s earnings before interest, taxes, depreciation and amortization (EBITDA) will improve. Lease payments will be treated as financing cash outflows in the statement of cashflows. Under current U.S. GAAP operating lease rent payments are treated as an operating cashflow. The new model will result in additional 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.

The financial statement and financial ratios will be impacted for lessors as well. Income will be front loaded based on the proposed rules. Companies that base bonuses on income may need to revisit their compensation plans. How the new rules effect financial statements and ratios will vary from company to company.

New lease accounting changes are on their way which will significantly affect financial statements. Companies should be proactive to determine how these changes will affect their financial statements and any financial arrangement that they have covenants with.

 
 
 
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