Approach D: Level expense recognition explained

As mentioned in prior posts, one of the options that the FASB & IASB are looking at for expense recognition under the new lease accounting standard is to have a single lease expense item in the income statement, which would be level over the life of the lease no matter what the cash flows. The following is my understanding of how the calculations would work.

We'll take three leases, each of which is five years long (1/1/2012 - 12/31/2016). Rent is paid monthly in advance (i.e., first payment is due the first day of the lease), and rent payments total $6,000 over the five years. All of them have an initial asset & obligation value of $5,000 (this requires different interest rates to deal with the different payment scenarios, which implies that the interest rate is the rate implicit in the lease.) Lease NoChange has rent of $100/month for the entire term. Lease Increase starts at $80/month for the first year, then increases by $10/month each year (i.e., $90/month in year 2, up to $120/month in year 5). Lease Holiday has no rent for the first year, then $125/month for the remaining 4 years.

The chart below shows the varied results for the asset and obligation with each scenario. Where the rent isn't equal over the life of the lease, there is also a deferred rent liability or asset (as with current operating leases that are leveled) and if the lease is early terminated, there will be a gain or loss.

"Straight line" is simply for reference purposes, to show what the profile would be with equal amortization each period. All of the examples would have slower amortization in the early months (the only way amortization would be faster than straight line in the early months would be if rent were higher at the beginning than at the end of the lease, which is rare; reduced rents for just a small portion of time at the end of the lease wouldn't change the overall picture).

How will the journal entries work? The following is my best guess, using the NoChange example above, for its first month (interest rate used is 7.69%):

 

Gross asset			5,000.00
	Current obligation			879.26
	Long term obligation			4,120.74
Setup of capital lease
Current obligation			100.00
	Cash capital rent payment			100.00
Capital lease rent payment
Long term obligation			73.59
	Current obligation			73.59
Reclassification of obligation from long term to current
Interest expense			31.40
	Accrued interest			31.40
Interest accrual
Depreciation expense			68.60
	Accumulated depreciation			68.60
Depreciation accrual
Lease expense			100.00
	Interest expense (reversal)			31.40
	Depreciation expense (reversal)			68.60
Reclassification to lease expense

While you might merge the last three transactions together, that's going to make it harder to see where the activity in interest and depreciation is coming from. Interest expense is calculated on the outstanding obligation after that month's payment (4900 x 7.69% / 12 = 31.40). Depreciation expense is plugged: 100 (average monthly rent) - 31.40 (interest expense) = 68.60.

Balances in the balance sheet accounts at the end of the first month:

Gross asset	5,000.00
Accumulated depreciation		68.60
Current obligation		852.85
Long term obligation		4,047.15
Accrued interest		31.40

You may notice that no interest is paid in the first rent payment. This is because with a lease that is paid in advance, as almost all leases are, the first payment is due the first day of a lease, before interest has had time to accrue. Interest expense accrues during the month and is paid the beginning of the following month. Unfortunately, while the journal entries example in FAS 13 shows this, all of the examples provided in the original exposure draft, and in all the discussion papers that I've seen generated by the staff, have used leases paid in arrears. That makes the calculations a bit simpler, but virtually no leases are written that way. I hope the staff will include a payments-in-advance example in the Revised Exposure Draft (and final standard), since this concept is often hard to get lessees and lessors to understand and accept. For leases paid in advance, the change in net asset for a period under Approach D equals the combined change in current obligation, long term obligation, and accrued interest.

The transactions wouldn't vary greatly for Increase and Holiday, but in those cases the Lease Expense won't match the current month's Cash Capital Rent Payment, and the depreciation expense will be smaller or even negative (for Holiday). The balancing entry would be booked to deferred rent liability.

I hope we'll see a more official presentation of how to account for leases using Approach D next month.