Monday, April 6, 2009

Lease Accounting: The New Approach

Continuing with the review of the boards' Discussion Paper on lease accounting:

The basic reason for the revision of lease accounting is that the boards have concluded that current accounting “fails to represent faithfully the economics of many lease contracts,” which they believe entail rights (to use property) and obligations (to pay rent) that are not recognized on the balance sheet with a current operating lease.

The boards started their analysis with a simple 5 year lease, non-cancellable, no renewal options, no purchase option, and no residual value guarantees. Based on both boards’ conceptual understanding of assets and liabilities, they conclude that the right to use the machine qualifies as an asset, and that the obligation to pay rentals is a liability. The obligation to return the property, they conclude, should not be treated as a liability (while the lessee has possession of the property, it has no right to the property once the lease term is up, and is then essentially a custodian until the property is returned).

Therefore, the boards conclude that leases should be recognized as a right-to-use asset with a matching liability for rents. This new approach, they conclude, will meet many of the criticisms of the current standard, by putting all leases on the balance sheet, improving comparability between companies and transactions, reducing the opportunities to structure transactions as “unrecognised financing,” and being more consistent with the boards’ conceptual frameworks and recent standards in other areas.

Many leases are more complex, and the boards considered options to renew, to terminate early, to purchase the asset, to pay variable or contingent rentals, and to make residual value guarantees. They considered recognizing these components separately, but decided that the problems outweighed any possible benefits, and that a single asset and obligation, encompassing all rights and obligations, should be recognized.

The boards rejected three other approaches:

“Whole asset:” The premise is that during the lease term the entire asset is under the control of the lessee, who should thus recognize the full economic value of the asset on the balance sheet, for both the term of the lease and the remaining value at lease’s end. However, the boards consider that the economic position of a lessee is quite different from a purchaser; it overstates assets and liabilities, because it considers as an asset or liability the value of the property after the end of the lease, which is not available to the lessee; and it raises definitional issues, since very short-term leases would seem inappropriate to treat this way, and defining what should and shouldn’t be included returns to the discredited capital/operating distinction.

“Executory contract:” This method would treat all leases more or less like current operating leases. The boards rejected this because they are convinced that leases do give rise to assets and obligations.

“Existing standard:” The boards consider the current approach unsuitable because 1) operating leases, which in their view do actually give rise to assets and obligations, currently are accounted for without balance sheet effect; 2) similar transactions (those just above and just below the line separating capital and operating leases) are accounted for very differently, reducing comparability and increasing structuring opportunities; and 3) They find it difficult to define a good dividing line between capital and operating leases.

Respondents are asked whether they agree with the boards’ conclusions, and if not, what analysis of leases and components they would prefer and why.

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