The most recent Leases ED has considerable difference from the August 2010 draft. The May 2013 draft will affect lessees and lessors. According to FASB, “Leasing is a means of gaining access to assets, obtaining financing, and reducing an organization’s exposure to the risks of asset ownership.” Companies lease items such as real estate, vehicles, and equipment. Since leasing is so prevalent in the accounting makeup of a company, it is very important for users of financial statements to have a clear and concise understanding of a company’s leasing activities. The existing accounting models accounting models require lessees and lessors to identify their leases as capital or operating leases. Depending on the type of lease depends on how the lease will be accounted for. Thus, critics believe that the financial statements do not always provide a faithful representation of leasing transactions. Also, the SEC (Securities and Exchange Commission) staff identified leasing is such a topic that needed to be addressed since it is a form of off balance sheet accounting. The SEC recommended that changes should be made to provide greater transparency to financial reporting.
Thus, FASB and IASB began working together to improve the accounting for lease rights and obligations. FASB issued a proposed standards update, Leases (Topic 842), which is a revision to Leases (Topic 840). This document is considered a revised Exposure Draft (ED) and would require assets and liabilities arising from leases to be recognized on the balance sheet. Thus, the new standards will provide more transparency and disclose key information. The main objective is that a company should recognize assets and liabilities that result from a lease. A lessee would recognize assets and liabilities for a maximum term of more than 12 months. FASB indicates, “The recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee would depend primarily on whether the lessee is expected to consume more than an insignificant portion of the economic benefits embedded in the underlying asset.”
In the United States under current accounting standards, leases are characterized as either operating or capital. In the United States under current accounting standards, leases are characterized as either operating or capital. With an operating lease, rent expenses are written off in the year they occur and appear on the organization's income statement as an operating expense to arrive at net operating income. The income statement more or less reflects cash flow. Under the proposed changes, all leases would be treated as capital leases. Understanding why this change is significant requires some background.
Also, the revised ED sets forth standards for lease classification. The principle for the lease classification for determining between two lease types would be based on the portion of the economic benefits of the underlying asset expected to be consumed by the lessee over the lease term. Ernst and Young’s article “Leases Re-exposed: Another Attempt at Improving Lease Accounting” breaks out the classification of leases as follows:
Leases of assets that are not property (e.g., equipment, vehicles) would be classified as Type A leases unless one of the following two criteria is met:
The lease term is for an insignificant part of the total economic life of the underlying asset
The present value of the lease payments is insignificant relative to the fair value of the underlying asset
Leases of property (i.e., land, a building or part of a building) would be classified as Type B leases, unless one of the following two criteria is met:
The lease term is for the major part of the remaining economic life of the underlying asset
The present value of the lease payments accounts for substantially all of the fair value of the underlying asset
The article then details that under the revised ED, Type A leases would cause accelerated