Magazine article The CPA Journal

Lease Accounting-Up for Renewal: A Review of FASB and the IASB's Exposure Draft

Magazine article The CPA Journal

Lease Accounting-Up for Renewal: A Review of FASB and the IASB's Exposure Draft

Article excerpt

FASB and the IASB jointly issued an exposure draft (ED) in May 2013 that proposes sweeping changes to existing lease accounting standards. If it were adopted in its current form, almost all fixed-payment, long-term leases (defined as more than one year in length) would have to be reported as an asset and a liability on a lessee's balance sheet. This article provides a highly summarized overview of the ED's major provisions, focusing exclusively on the significant changes contemplated in lessee accounting.

Overview

Leasing is a significant economic activity for many businesses. Most long-term leases are accounted for as operating leases under existing U.S. GAAP. But in FASB's view, this treatment does not result in faithful representation, because it results in significant assets and liabilities not being reported on a company's balance sheet. The newly proposed ED seeks to enhance the representational faithfulness of the lessee's statement of financial position by requiring the fixed portion of all long-term leases to be capitalized, which the ED notes is the "core principle of the proposed requirements." If adopted in its present form, the ED would substantially limit companies' ability to engage in off-balance sheet financing through leasing activities, which some observers believe to be a clear deficiency in existing reporting practices.

Most significantly, the ED eliminates the present distinction in U.S. GAAP between operating and capital leases. Although it permits a lessee to elect not to capitalize shortterm leases, it requires the lessee to capitalize the fixed portion of all long-term leases (including leases presently classified as operating leases). The ED also permits straight-line expense recognition for long-term leases of property (defined as "land and/or a building or part of a building"). Exhibit 1 summarizes the core features of lessee accounting under the ED.

Expense Recognition on Property (Real Estate) Leases

The magnitude of real estate leases in developed economies eclipses that of other forms of leases. Moreover, the scale of real estate leasing can be especially significant in some industries, such as retail. Although most accountants agree that financial reporting is improved by reporting most long-term leases as assets and liabilities, different views exist on the proper timing of expense recognition for leases in general, and for real estate leases in particular. Indeed, a major theoretical sticking point in the ED's joint development by FASB and the IASB was the reconciliation of differing views on expense recognition for real estate leases.

Under GAAP, and thus under the prevailing conceptual mindset in the United States, one important consequence of capitalizing a lease has been to front-load expense recognition over the lease term. (The front-loading occurs because the present value of the lease liability is higher in earlier years, as is computed interest expense.) Although the front-loading of lease expense may be representationally faithful in the case of a long-term lease of transportation equipment, many accountants balk at the notion of front-loading expenses for most real estate leases. The unique status of real estate is aptly illustrated by considering the case of a retail- er that entere into a five-year, fixed-payment lease for space in an established shopping mall. It is difficult to justify why expense should be higher in the first year of the lease and lower in the fifth year, when all that is consumed over the lease term is space for a storefront. …

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