Changes on the horizon for lease accounting: FASB/IASB continue to wrestle with proposals

The joint lease accounting project undertaken by the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) has been controversial from its inception. An exposure draft of proposed changes to existing standards was issued in August 2010, and generated numerous comments and criticisms. The FASB and IASB have continued to wrestle with this project and, on May 16th, they issued a revised exposure draft describing proposed changes to lease accounting. This revision is a result of their redeliberations of the proposed guidance in the 2010 exposure draft, taking into account the many concerns expressed by various interested parties. While the FASB and IASB proposals are very similar, this article will focus on the basics of the FASB proposal, in particular on what it means for real estate leases. In general, for owners of real property, the accounting will be very similar to the current operating lease accounting methodology. The underlying assets (land and buildings) will continue to be recognized on the balance sheet, and the base rent income will be recognized over the lease term, typically on a straight-line basis. Most variable lease payments will be excluded from the calculation, and payments to be made in optional periods would only be included if the tenant has a significant economic incentive to extend the lease or not to exercise an option to terminate the lease. While the accounting for landlords may not be changing significantly, it may be useful for landlords to understand how the proposed changes will affect lease accounting from the tenant perspective and some of the potential implications. For most leases of property, the tenant will have to record both an asset and corresponding liability related to the lease. The asset represents the tenant's right to use of the property, and the liability represents the tenant's obligation to pay rent for such use of the property. Both the asset and liability will initially be measured at the present value of the lease payments. This right-of-use asset and the discount on the lease liability will then be amortized as a single lease cost over the term of the lease. The right-of-use asset will be amortized on a straight line basis, factoring in the amortization of the discount on the lease liability. Generally, the effects of this methodology will not be different than the current operating lease accounting which requires that total lease payments be expensed on a straight-line basis over the term of the lease. However, the most significant difference will be the asset and liability reflected on the balance sheet. Under current standards, operating leases are off-balance sheet and disclosed in the notes to the financial statements. For leases of assets other than property, such as equipment, vehicles or aircraft, the lessee would recognize a right-of-use asset and lease liability, initially measured at the present value of the lease payments. The asset would be amortized over the term of the lease, and the unwinding of the discount on the lease liability would be recognized separately as interest expense. Lessors of assets other than property would derecognize the underlying asset and recognize a lease receivable and a residual asset. The unwinding of the discount on the lease receivable and the residual asset would be recognized as interest income over the term of the lease. The proposed changes would require these right-of-use assets and lease liabilities to be presented on the balance sheet, or disclosed in the notes to the financial statements, separately from other assets and liabilities. This treatment requiring inclusion of right-of-use assets and lease liabilities on the balance sheet, as well as the situations where the underlying assets are derecognized, may consequently affect various financial covenants and ratios commonly included in many financing agreements, incentive compensation agreements, and other contractual arrangements based upon or linked to financial benchmarks. These changes are still only proposals, and the FASB and IASB are seeking comments from all concerned parties. A final standard will probably not be issued until sometime in 2014. It seems likely that there will be some changes in accounting for leases, but it is too soon to tell exactly what those will be. Stay tuned! Sandy Klein, CPA, is a partner at Shanholt Glassman Klein Kramer & Co., New York, N.Y.