Initial measurement of leases

Continuing with the review of the boards' Discussion Paper on lease accounting. Today's installment covers chapter 4.

Summary:

A lease is to be valued at the present value of the rents due, using the lessee's incremental borrowing rate as the interest rate. The asset and obligation start with the same value. There is no limitation to the asset's fair market value (unlike the current standards).

Detailed review:

Conceptually, the boards wish to determine the initial asset and obligation of the lease by determining its fair value. The boards decided that the fair value of the obligation to pay rentals is not always obvious, and therefore decided to use a discounted cash flow methodology for measurement. This is the same type of methodology used currently for capital leases, and similar to some other financial instruments.

Calculating a discounted cash flow requires deciding on an interest rate to use. The boards considered two possible rates to use:

• The interest rate implicit in the lease (the discount rate needed to make the present value of the rents plus the unguaranteed residual equal to the fair value of the leased asset plus the lessor’s initial direct costs)
• The lessee’s incremental borrowing rate (the interest rate the lessee would pay on a similar lease or to borrow a similar amount of money over a similar term to purchase the asset)

For both rates, the definition used is that of IAS 17, not FAS 13, which is slightly different (most notably, FAS 13 doesn’t refer to the lessor’s initial direct costs for the implicit rate).

The boards rejected the implicit rate because it is often difficult for lessees to determine (they may not know the residual value or the initial direct costs); it was particularly noted that for many leases currently considered operating, the unguaranteed residual can be a large percentage of the total value, and thus mistakes in valuation could significantly affect the calculation.

The boards decided to use the present value of the rents, at the incremental borrowing rate, as the value of both the asset and the obligation at the inception of the lease. They rejected a separate calculation of the fair value of the right-to-use asset, considering “measurement at cost” for the asset to be consistent with the initial measurement of other non-financial assets and less costly to determine than a fair value measurement.

This means that the current capital lease requirement of limiting the gross asset value to not more than the fair market value of the asset will be eliminated.

Those who disagree with the boards’ conclusions are asked to offer their recommended alternative and reason for the switch.

EZ13 has an option to report operating leases capitalized using their incremental borrowing rate, as contemplated by the discussion paper, so you can see today how this change would affect your reporting.