The final standard for lease accounting will include a provision for two different kinds of leases—those that will qualify for straight-line expensing in the income statement and those that will be capitalized. At least that's the latest determination of the Financial Accounting Standards Board and the International Accounting Standards Board as they continue to struggle with how to recognize lease obligations in the income statement.
After extensive mental gymnastics over how to recognize lease liabilities in a way that best reflects the economics, the IASB and FASB agreed on a two-model approach. The boards also tentatively determined they will require lessees to make some judgments about whether through a particular lease they have acquired more than an insignificant portion of the underlying asset. Where they acquire more than an insignificant portion, they will be required to capitalize the lease; where they acquire less than an insignificant portion, they will be permitted to recognize the expense evenly in the income statement over the lease term.
“The Boards carefully considered the diverse views of stakeholders about whether the income statement profile of all leases should be the same,” said FASB Chairman Leslie Seidman in a statement. “On balance, we decided that leases that convey a relatively small percentage of the life or value of the leased asset should be recognized, evenly over the lease term.”
When FASB and IASB published their initial proposal to bring all leases on the balance sheet, it treated all leases alike, giving rise to a liability that would be discounted and amortized to determine the expense that would flow to the income statement. The board heard extensive criticism that such front-loading of the interest cost associated with some short-term leases did not reflect the true economics of the transaction.
The boards briefly considered and dismissed a two-model approach last summer, believing it to be too complicated to draw a line between lease treatments. The boards are trying to do away with the structuring of lease transactions that occurs today as companies navigate bright-line differences between capital leases that must be amortized and operating leases that can be expensed.
In their latest thinking on how to distinguish between leases, the boards are planning to outline some criteria to help companies make judgments about whether they have acquired more than an insignificant portion of an underlying asset through a lease, according to FASB spokesman John Pappas. As a “practical expedient,” the boards are planning to tell companies that leases of property -- such as land, buildings, or some combination -- should be accounted for using the straight-line approach unless the lease term is for the major part of the economic life of the underlying asset or the present value of fixed lease payments accounts for substantially all of the fair value of the underlying assets.
For leases of assets other than property, such as equipment, the lease should be accounted for using the approach established in the original exposure draft unless the lease term is an insignificant portion of the economic life of the underlying asset or the present value of the fixed lease payments is insignificant relative to the fair value of the underlying asset.
The boards plan to publish a revised exposure draft of the standard in the third quarter of 2012 with a target to finalize the standard in 2013.