Wednesday, April 22, 2009

DP Review: Subsequent measurement

Continuing with the review of the FASB & IASB Discussion Paper on revising lease accounting. Today's installment covers chapter 5.


  • Assets and obligations are to be measured during the life of the lease using an amortized-cost approach.
  • Assets and obligations are measured separately, so that during the life of the lease, the net asset typically will not equal the remaining obligation (just as is the case with current capital leases).
  • If the cash flows change, the present value of the additional rent is added to the remaining asset and obligation.
  • Board disagreement: The FASB wants to keep the interest rate as the initial incremental borrowing rate during the entire life of the lease. The IASB wants to update the rate to the current market rate during the lease’s life.

Detailed review:

The boards first dispense with one possible approach, a “linked” approach that causes the asset and obligation to be reduced by the same amount each period. Using this method, the depreciation expense would be equal to the obligation reduction; since the interest is equal to rent minus obligation, the result is that the expense recognized each period is identical to the rent paid.

The problems, in the boards’ view, are that

  1. This approach is being promoted in conjunction with the idea of maintaining a distinction between leases that are currently classified as “capital” and “operating.” The proponents would apply this method only to currently operating leases. Current capital leases would be treated as purchases, with depreciation and interest calculated the way they are now. This means that similar leases (those just above and just below the threshold dividing capital and operating leases, whatever that threshold may be) would be accounted for quite differently, which is one of the problems this revision is intended to resolve.
  2. This approach results in different accounting than that used for other financial liabilities, which again reduces comparability.
  3. The asset and liability for a lease during its term are not always linked, since impairment and other changes in the asset value are independent of the rental obligation.

Because of these problems, the boards rejected this approach, choosing instead a “non-linked” approach to measuring assets and obligations (i.e., they are calculated independently of each other).

Obligation measurement

The boards also rejected using a fair value method of measuring the ongoing obligation to pay rentals, considering it inconsistent with other financial liabilities, inconsistent with the initial measurement of the lease based on cost, and burdensome in cost and complexity to comply with.

Instead, the obligation to pay rentals is to be valued based on the discounted present value of the rents. However, the interest rate to use is a point of disagreement between the boards. The FASB wants to use the incremental borrowing rate from the inception of the lease. The IASB, however, believes the rate should be the current incremental borrowing rate. The FASB rejected that for essentially the same reasons as they rejected fair value measurement, while the IASB believes that using market rates is consistent with IAS 37 and provides more relevant information to users of financial statements. However, the IASB did not decide whether remeasurement should happen at each reporting date or only when there is a change future cash flows (i.e., a change in rent due).

If the future rents change (such as due to the exercise of a renewal), the boards discussed how the change should be recognized. Rather than keeping the remaining or initial obligation amount the same and calculating a new interest rate needed to make the present value of the rents match that (which could result in very high interest rates), they concluded that the additional rent should be added to the obligation by present valuing it using the incremental borrowing rate (the FASB recommending the original incremental rate, with the IASB recommending the current rate).

Asset measurement

As with obligations, the boards rejected a fair value approach to valuing the asset, for basically the same reasons. Therefore, they decided that assets should be amortized over the shorter of the lease term or the economic life; if title to the asset is expected to transfer at the end of the lease, then the economic life should be the amortization term. This is basically the same as the current standard for capital leases.

Some FASB members want to call the reduction in asset value “rent expense” rather than “depreciation” or “amortization,” at least for some leases, but this option is not fully worked out, and clearly reflects a minority opinion (which apparently none of the IASB is interested in).

The asset should also be reviewed for impairment, but the boards haven’t yet considered how that will be done.

There is no reference here to how (or if) the asset should be changed if the future rents change. In the next chapter, they state that the asset should be adjusted the same way the obligation is.

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