Introducing “Approach Y”: A Better Lease-Accounting Model for Lessees (Part 3)
(Previous Posts: Part 1, Part 2)
Here is the third in a series of working papers that I am preparing to explain “Approach Y”—a lease-accounting model for entities that are lessees. The new working paper evaluates the conceptual bases of Approach Y and three other approaches with regard to subsequently measuring right-of-use (RoU) assets. The results of this evaluation support the conclusion that Approach Y has a better conceptual basis for the subsequent measurement of RoU assets than any of the other three approaches has.
Please find the new paper attached.
Attachments
Approach Y – Working Paper 3 (PDF)
I welcome your feedback on the new working paper. I also invite you to watch for my additional working papers.
Bruce,
Interesting stuff. From watching the shifts in “decisions to date”, the IASB and FASB appear to still be searching for the “better mouse trap” with regard to leases.
One thing about Approach Y puzzles me though. In today’s accounting for a capital lease, we initially put the asset and liability on the books at present value. Interest expense over the life of the lease equals total cash payments minus this present value. Cumulative depreciation expenses over the life of the lease (assuming no salvage value) equals the present value. So when we add interest expense plus depreciation expense, they equal the cash outflow for lease payments. As an instructor, this property of accrual accounting is always reassuring – the total expenses equal the total cash paid.
In approach Y, we have a third income statement item – the accreted return on the leased asset. If this third component is added to the other two, then I do not see how cash paid for the lease reconciles with the net of the income statement items over the life of the lease. That seems like a problem to me. But I may be missing something.
Robert,
Thanks for your question. I have prepared a simple Excel file (available via this link) to compare and contrast Approach Y with the treatment of capital leases under current U.S. GAAP. The Excel file helps to illustrate my answer to your question.
First, some assumptions:
• The lease has no guaranteed residual value, no penalty for non-renewal, and no bargain purchase option.
• The present value of the minimum lease payments is less than or equal to the fair value of the underlying asset.
Next, I concur with your three validation criteria, specifically:
• “Interest expense over the life of the lease equals total cash payments minus [the initial] present value.”
• “Cumulative depreciation expenses over the life of the lease (assuming no salvage value) equals the [initial] present value.”
• “[W]hen we add interest expense plus depreciation expense, they equal the cash outflow for lease payments… total expenses equal the total cash paid.”
I propose an additional validation criterion: The periodic expensing of the recognized asset (generally referred to as “depreciation” under current capital-lease treatment) should reflect the pattern in which economic benefits from the asset are realized over time. For example, if economic benefits from the asset are realized uniformly over time, then the periodic expensing of the asset should be uniform in amount over time.
We know that the treatment of capital leases under current U.S. GAAP satisfies all four of these validation criteria. But does Approach Y also satisfy all four criteria? Yes, it does.
In the Excel file, on the “Approach Y” sheet, observe that what we typically think of as interest that accrues on the recognized liability is labeled “Time-Value Accretion of Lease-Payment Liability.” This line item is analogous to the “Interest Expense” line item on the “Capital Lease (Current GAAP)” sheet. Additionally, what we typically think of as depreciation that accrues on the recognized asset is labeled “Consumption/Expiration of Right-of-Use Asset.” This line item is analogous to the “Depreciation Expense” line item on the “Capital Lease (Current GAAP)” sheet. The “Approach Y” sheet also contains a line item labeled “Time-Value Accretion of Right-of-Use Asset.” This line item has no analog on the “Capital Lease (Current GAAP)” sheet.
As the Excel file illustrates, the total expense, which is labeled “Net Effect on Comprehensive Income” on both sheets, has three components under Approach Y and two components under current capital-lease treatment.
When we examine the “Approach Y” sheet to assess whether Approach Y satisfies the four validation criteria, we find:
• The total time-value accretion of the lease-payment liability (cell H16), which is analogous to Interest Expense, equals (in absolute value) the total cash payments (cell H4) less the initial present value of the liability (cell B8). Thus, the first validation criterion is satisfied.
• The total changes to the asset, which are the net of the total time-value accretion of the right-of-use asset (cell H17) and the total consumption/expiration of the right-of-use asset (cell H18, analogous to Depreciation Expense), equal the initial present value of the asset (cell B9). Thus, the second validation criterion is satisfied.
• The total Net Effect on Comprehensive Income (cell H19) equals the total cash outflow for lease payments (cell H4). Thus, the third validation criterion is satisfied.
• The consumption/expiration of the right-of-use asset reflects the pattern in which economic benefits from the asset realized over time. When, for example, the economic benefits from the asset are realized uniformly over time, the Consumption/Expiration of Right-of-Use Asset amounts are also uniform over time. Thus, the fourth validation criterion is satisfied.
While Approach Y satisfies all four of the validation criteria, it does so in a manner somewhat different from that of current capital-lease treatment. Specifically, observe that the consumption/expiration of the right-of-use asset amount is higher under Approach Y than the Depreciation Expense amount is under current capital-lease treatment. Over the term of the lease, the higher consumption/expiration amounts offset the time-value accretion of the right-of-use asset, which has no analog in current capital-lease treatment.
Also observe that as of the end of each period, the carrying amount of the asset is generally different under Approach Y than it is under current capital-lease treatment. The upshot of this is that Approach Y more faithfully represents the economic position of the entity by measuring the RoU asset more accurately than current capital-lease treatment and other proposed approaches do. If it is not clear that Approach Y measures the RoU asset more accurately, let me know—I will be happy to demonstrate that it does.
Please see my followup post (Part 4) here. Attached to it is a fourth working paper that summarizes the structural aspects of financial-statement presentation and disclosure under Approach Y and three other approaches. The summary supports the conclusion that financial statements prepared under Approach Y would be more decision-useful than financial statements prepared under the other approaches.