Type B lease accounting

Since it seems highly likely that Type B lease accounting will survive for current lessee operating leases in the U.S. (with perhaps a few leases at the margins moving in and out of such treatment), I thought it might be worthwhile to look in more detail at some examples of how Type B accounting will work. (Let's hope they come up with a nicer name for it; "type A" and "type B" are totally arbitrary, and don't at all describe the accounting involved.)

With simple leases (no initial direct costs, the same rent paid throughout the life of the lease), the calculations are pretty simple: both the asset and liability are, at any given moment, equal to the present value of the remaining rent (excluding service components, of course). But life is rarely simple. So let's look at a few variations on a theme.

Example #1: We'll start with a simple lease of five years, starting 1/1/2014, paid yearly in advance (i.e., first payment due first day of the lease), rent 10,000 per year, and an incremental borrowing rate of 6%. There are no initial direct costs.

The present value of the rents at inception is 44,651.06. Both the initial liability and asset are set to that amount. The balances at the end of each year, and the effective interest calculated (not expensed, but used to determine the drawdown on the balance sheet accounts), are as follows:

End Date	Liability	Asset	Effective Interest
Initial	(44,651.06)	44,651.06
12/31/2014	(36,730.12)	36,730.12	2,079.06
12/31/2015	(28,333.93)	28,333.93	1,603.81
12/31/2016	(19,433.96)	19,433.96	1,100.04
12/31/2017	(10,000.00)	10,000.00	566.04
12/31/2018	(0.00)	0.00	0.00

As you can see, the liability and asset are identical at all times. The reduction in each is the rent (10,000) less the effective interest (for 2014, 10,000 - 2,079.06 = 7,920.94). The yearly expense is the 10,000 rent.

Example #2: Many leases have changes in rent during the life of the lease. Let's say that for this lease, the rent increases to 11,000 per year starting 1/1/2016 (start of 3rd year).

End Date	Liability	Asset	Effective Interest
Initial	(47,172.77)	47,172.77
12/31/2014	(39,403.13)	38,803.13	2,230.37
12/31/2015	(31,167.32)	29,967.32	1,764.19
12/31/2016	(21,377.36)	20,577.36	1,210.04
12/31/2017	(11,000.00)	10,600.00	622.64
12/31/2018	(0.00)	0.00	0.00

The yearly expense is 10,600 (the average of the rent over the lease term). Effectively, the difference between the cash and level rent is recognized in the asset, instead of the FAS 13 practice of setting up a deferred rent liability.

Example #3: Going back to the simple lease of 10,000 rent per year. This time we add initial direct costs of 2,000, which is added to the asset but not the liability.

End Date	Liability	Asset	Effective Interest
Initial	(44,651.06)	46,651.06
12/31/2014	(36,730.12)	38,330.12	2,079.06
12/31/2015	(28,333.93)	29,533.93	1,603.81
12/31/2016	(19,433.96)	20,233.96	1,100.04
12/31/2017	(10,000.00)	10,400.00	566.04
12/31/2018	(0.00)	0.00	0.00

The yearly expense is 10,400 (rent plus a straight-line portion of the initial direct costs).

Example #4: No initial direct costs. Payments are made in arrears (that is, the first payment is made at the end of the first year).

End Date	Liability	Asset	Effective Interest
Initial	(42,123.64)	42,123.64
12/31/2014	(34,651.06)	34,651.06	2,527.42
12/31/2015	(26,730.12)	26,730.12	2,079.06
12/31/2016	(18,333.93)	18,333.93	1,603.81
12/31/2017	(9,433.96)	9,433.96	1,100.04
12/31/2018	(0.00)	0.00	566.04

The yearly expense is 10,000 (the yearly rent, same as example #1). You may notice that the effective interest for years 2-5 is identical to the interest for years 1-4 in examples 1 & 3.