Accounting for leases in the United States

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Accounting for leases in the United States regulated by the Financial Accounting Standards Board (FASB) by the Financial Accounting Standards Number 13. These standards were effective as of January 1, 1977. These standards are currently under discussion for changes in FASB Topic 840, and finalization of new standards is not expected before late 2012.[1]

Contents

Introduction

A lease is a contract calling for the lessee (user) to pay the lessor (owner) for use of an asset for a specified period of time.[2] A rental agreement is a lease in which the asset is tangible property.[3] As there are many ways to view how these contracts affect the balance sheets of both the lessee and lessor, FASB created a standard for US accountants and businesses.

Accounting for leases by the lessee

The accounting profession recognizes leases as either an operating lease or a capital lease (finance lease). An operating lease records no asset or liability on the financial statements, the amount paid is expensed as incurred. On the other hand, a capital lease is recorded as both an asset and a liability on the financial statements, generally at the present value of the rental payments (but never greater than the asset's fair market value). To distinguish the two, the Financial Accounting Standards Board (FASB) provided criteria for when a lease should be capitalized, and if any one of the criteria for capitalization is met, the lease is treated as a capital lease and recorded on the financial statements. The primary standard for lease accounting is Statement of Financial Accounting Standards No. 13 (FAS 13), which has been amended several times; it is known as topic 840 in the FASB's new Accounting Standards Codification. In July 2006, the FASB and the International Accounting Standards Board (IASB) announced the commencement of a joint project to comprehensively reconsider lease accounting. The boards' stated intention is to recognize an asset and obligation for all leases (in essence, making all leases capital leases). The projected completion of the project is now late 2012.[4][5] The basic criteria for capitalization of a lease by lessee are as follows:

These are called the 7(a)-7(d) tests, named for the paragraphs of FAS 13 in which they are found.

If any of the above are met, the lease would be considered a capital or financing lease and must be disclosed on the lessee's balance sheet. Conversely, if none of the criteria are met, the contract is an operating lease, and the lessee will have a footnote in its balance sheet to that effect. Both parties (lessor and lessee) must review these criteria at the outset and determine independently the classification as it is possible to classify them differently (it is quite common, in fact, for a single lease to be considered a capital lease by lessors and an operating lease by lessees).

If the term of the lease does not exceed 12 months, the lease may be considered neither of the above criteria. These contracts are "rentals" and do not need to be disclosed in lessee's footnotes.

For a more in depth explanation, see the accounting textbook Intermediate Accounting, 11th ed, Kieso Weygandt Warfield.

Lessee Accounting

Under an operating lease, the lessee records rent expense (debit) over the lease term, and a credit to either cash or rent payable. If an operating lease has scheduled changes in rent, normally the rent must be expensed on a straight-line basis over its life, with a deferred liability or asset reported on the balance sheet for the difference between expense and cash outlay.[6]

Under a capital lease, the lessee does not record rent as an expense. Instead, the rent is reclassified as interest and obligation payments, similarly to a mortgage (with the interest calculated each rental period on the outstanding obligation balance). At the same time, the asset is depreciated. If the lease has an ownership transfer or bargain purchase option, the depreciable life is the asset's economic life; otherwise, the depreciable life is the lease term. Over the life of the lease, the interest and depreciation combined will be equal to the rent payments.

For both capital and operating leases, a separate footnote to the financial statements discloses the future minimum rental commitments, by year for the next five years, then all remaining years as a group.

Other lessee financial accounting issues:

Lessor Accounting

Under an operating lease, the lessor records rent revenue (credit) and a corresponding debit to either cash/rent receivable. The asset remains on the lessor's books as an owned asset, and the lessor records depreciation expense over the life of the asset.

Under a capital lease, the lessor credits owned assets and debits a lease receivable account for the present value of the rents (an asset, which is broken out between current and long-term, the latter being the present value of rents due more than 12 months in the future). With each payment, cash is debited, the receivable is credited, and unearned (interest) income is credited.

Other Issues

Usually, when a lease is entered into, a security deposit is required. There are two types of security deposits:

Calculation

How to calculate the lease rate:

[Monthly Lease Payment] x [Term (months)] = [Total amount out of pocket]
[Total amount out of pocket] - [Financed amount] = [Total finance charge]
[Total finance charge] / [Term (years)] = [Finance charge per year]
[Finance charges per year] / [Financed amount] = Annual Lease Rate

Lease Accounting Rule Changes

As part of their joint commitment to the “development of high quality, compatible accounting standards that could be used for both domestic and cross-border financial reporting”,[8] the IASB and the FASB agreed to priorities and milestones for convergence of lease accounting rules by 2011.[9] The project goal, “to insure that investors and other users of financial statements are provided useful, transparent, and complete information about leasing transactions in the financial statements”, reflects investor concerns that current accounting standards fail to clearly portray the resources and obligations from leases in a complete and transparent manner.[10] These changes will increase transparency within the rules and prevent a loophole that allows for off-balance-sheet financing through leases.

Project Timeline

The project commenced in 2006. The targeted completion date has been extended several times, and is now late 2012.[9] Other critical dates within the project include;

  • issuance of a Discussion Paper - Leases: Preliminary Views - on 19 March 2009 with a public comment period open until 17 July 2009[11]
  • Issuance of joint Exposure Drafts on 17 August 2010 with a public comment period open until 15 December 2010[11]
  • Issuance of a second joint Exposure Draft: announced on 21 July 2011[12], expected to be released in the second half of 2012.

The Effective Date of the new standard - date at which time all companies must follow the new lease accounting standard when preparing financial statements –may not be known until the final rule is issued, but 2015 or 2016 is now considered the likely effective date. However, companies will be required to restate comparable years in their annual reports. Most U.S. companies include two years of comparables in their annual report, so the new standard would be implemented as of 2013 or 2014.

Present vs. New Lease Accounting Standards

The proposed lease accounting rules eliminate the FAS 13 test which classifies leases as operating leases or capital leases. Unlike current lease accounting standards, all leases will be accounted for as assets and liabilities on the balance sheet – on the asset side as ‘right-to-use-assets’ and on the liability side as lease liabilities.[13]

While the first Exposure Draft envisioned including likely rent (contingent rents and options to renew) in addition to minimum required rent payments, subsequent decisions by the boards have reversed these plans, making the proposed accounting for lessees similar to that of existing capital leases. Lessor accounting will be similar to current direct finance lease accounting, though with the potential for recognizing a profit at the beginning of the lease term in certain circumstances. Leases with a maximum term of 12 months or less would be treated in accordance with current operating lease rules.

Impact of New Lease Accounting Rules

According to the U.S. Securities and Exchange Commission (SEC), the financial impact of the proposed lease accounting rule changes is estimated to add more than $1.3 trillion of operating lease obligations to corporate balance sheets.[14] This will have a profound and lasting effect on the financial and real estate strategies and processes of global companies as real property leases are very large for many companies.[14]

Illustration of New Lease Accounting Source: TRIRIGA

See also

Documentation for FAS 13

Project Update on Topic 840

FASB Topic 840 Documentation

References

  1. ^ FASB Current Technical Plan and Project Updates, retrieved 3/16/2012
  2. ^ Stickney and Weil 2007 p. 791 (Glossary of Financial Accounting: An Intro. to Concepts, Methods, and Use 12e).
  3. ^ 34 Am. Jur. 2d Federal Taxation ¶ 16762 Section 467 rental agreements defined: “A rental agreement includes any written or oral agreement that provides for the use of tangible property and is treated as a lease for federal income tax purposes."
  4. ^ FASB Project Update: Leases
  5. ^ IASB Current Projects: Leases
  6. ^ FASB Technical Bulletin 85-3
  7. ^ Letter from SEC Chief Accountant, Feb. 7, 2005
  8. ^ A Roadmap for Convergence between IFRSs and US GAAP – 2006-2008: Memorandum of Understanding between the FASB and IASB, International Accounting Standards Board, February 27, 2006, http://www.iasb.org/NR/rdonlyres/874B63FB-56DB-4B78-B7AF-49BBA18C98D9/0/MoU.pdf 
  9. ^ a b Completing the February 2006 Memorandum of Understanding - A progress report and timetable for completion, Financial Accounting Standards Board, September 11, 2008, http://www.fasb.org/intl/MOU_09-11-08.pdf 
  10. ^ "FASB Formally Adds Project to Reconsider Lease Accounting" (Press release). Financial Accounting Standards Board. July 19, 2006. http://www.fasb.org/jsp/FASB/Page/news/nr071906.shtml. Retrieved January 19, 2011. 
  11. ^ a b Financial Accounting Standards Board. "FASB: Financial Accounting Standards Board". Archived from the original on 5 January 2011. http://www.fasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB%2FFASBContent_C%2FProjectUpdatePage&cid=900000011123. Retrieved January 19, 2011. 
  12. ^ Financial Accounting Standards Board. "IASB and FASB Announce Intention to Re-Expose Leasing Proposals". http://www.fasb.org/cs/ContentServer?site=FASB&c=FASBContent_C&pagename=FASB%2FFASBContent_C%2FNewsPage&cid=1176158769935. Retrieved July 26, 2011. 
  13. ^ Proposed Accounting Standards Update: Leases (Topic 840), Financial Accounting Standards Board, August 17, 2010, http://www.fasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175821125393&blobheader=application%2Fpdf 
  14. ^ a b The New Lease Accounting Standard and You, TRIRIGA Inc., July, 2010, http://www.tririga.com/information-center/whitepaper-view/new-lease-accounting-standard/index.html