When I first arrived at the FASB, my expectation was that the Leases project was winding down and we might have a final standard before I left.  This was also what the FASB website indicated.  How things have changed!  After an Education Session a couple of weeks ago and the joint IASB/FASB Board Meetings this week, it’s now safe to say we won’t see a new standard this year.  The optimistic forecast is to have a new ED issued sometime this summer, with a final standard issued next year.

Perhaps even more surprising is that after receiving feedback from various constituents, the Boards are re-deliberating lessee accounting.  I thought that was a done deal.  There are now essentially three different approaches to lessee accounting on the table.  I’ll walk you through an example of each to illustrate the differences.

First, the “Accelerated Expense” approach (AE).  This is the approach that both Boards agreed on in 2010, and what most accountants are familiar with because it’s similar to what we use for capital leases.  The Right-Of-Use (ROU) asset and the lease liability are recorded at the present value of the lease payments.  The asset is subsequently depreciated using straight-line, and the liability is accounted for using the effective interest method.

Using a numerical example, assume:

Lease period = 3 years

Fair value of underlying asset = $10,000

Estimated fair value of asset at the end of the lease term = $4,481 (important for following examples to note that about 55% of the underlying asset is consumed over the lease term)

Discount rate = 8%

Lease payment = $2,500

With these assumptions, the lessee records an asset and liability equal to the present value of the three $2,500 lease payments at the inception of the lease ($6,443 – I’m using ordinary annuity calculations).  The financial statement effects over the next three years are as follows:

 

Year 1

Year 2

Year 3

Depreciation expense

$2,148

$2,148

$2,147

Interest expense

$515

$357

$185

Total expense

$2,663

$2,505

$2,332

 

Ending Asset

$4,295

$2,147

$0

Ending Liability

$4,458

$2,315

$0

 

Critics have charged that the front-loading of expense over the life of the lease is significantly different from what would be recognized under an operating lease, which they believe to be more representative of the underlying economics in some cases.  The push-back on this issue has been loud enough that the FASB/IASB staffs have developed other approaches to address it, which could be used when the lease meets certain criteria (yes, a two-approach standard, similar to what we have now, is on the table).

In the “Interest-Based Amortization” approach (IBA), the leased asset and the lease liability are considered to be inextricably linked because they are based on the same enforceable contract, which is used to justify recording them at the same amount throughout the lease term.  Using the same facts above, the financial statement effects are as follows:

 

Year 1

Year 2

Year 3

Depreciation expense

$1,985

$2,143

$2,315

Interest expense

$515

$357

$185

Total expense

$2,500

$2,500

$2,500

 

Ending Asset

$4,458

$2,315

$0

Ending Liability

$4,458

$2,315

$0

The liability is accounted for the same way as before.  The depreciation expense is adjusted to ensure the asset is equal to the liability, which results in the total lease expense to be the same across all three years and equal to what would have been recognized using operating lease accounting.

The last approach is referred to as the “Underlying Asset Amortization” approach (UA).  Under this approach, the extent to which the asset is consumed by the lessee becomes critical to the accounting.  In my numerical example, the fair value of the residual asset in my example is $4,481 and therefore, about 55% of the asset is consumed by the lessee.  This approach introduces more complexity and requires the lessee to account for the residual asset as part of the depreciation recognized during the period.  Using my numerical example, I have required that the present value of the residual asset at lease inception is equal to the fair value of the leased asset ($10,000) less the present value of the lease payments ($6,443), which is probably what a lessor would require and equals $3,557.  This residual asset will be accreted over the 3-year lease term using the 8% discount rate and will become part of the depreciation expense, as follows.

 

Year 1

Year 2

Year 3

Accretion of residual asset

$285

$307

$331

Consumption of ROU asset

$1,840

$1,840

$1,840

Total Depreciation expense

$2,125

$2,147

$2,171

Interest expense

$515

$357

$185

Total expense

$2,640

$2,504

$2,357

 

Ending Asset

$4,318

$2,171

$0

Ending Liability

$4,458

$2,315

$0

 

I won’t crunch through the numbers, but it’s important to understand that if 0% of the leased asset is consumed over the lease period (i.e., land), then the UA approach yields the same results as the IBA approach.  In contrast, if 100% of the asset is consumed over the lease term, the UA approach yields the same results as the AE approach.

The problem associated with lessee accounting is further exacerbated by the fact that the Boards are currently not on the same page with respect to which model is more appropriate.  In cases where the Boards believe that the AE model does not accurately reflect the economics of the lease, the FASB has expressed a strong preference for the IBA model, whereas, the IASB is strongly in favor of the UA model.  I’m sure the SEC will be closely watching the developments as they consider whether/how to implement IFRS in the United States.