March 20, 2012
Reconsideration of conclusions leads to delay in leases project
The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) discussed their joint project on leases at their February 28-29, 2012 meeting. While no substantive decisions were reached at this meeting, the discussion and the potential changes to previously reached conclusions that are being reconsidered indicate that the release of a revised Exposure Draft (ED) will be delayed until at least the third quarter of 2012. The Boards had previously planned to issue the revised ED in the second quarter.
The tentative decisions reached by the Boards to-date would require that the lessee record a liability for the obligation to make lease payments and an asset for the right to use the underlying asset. The right-of-use (ROU) asset would be amortized (presumably on a straight-line basis), while the liability would be amortized using the effective interest method. This model would result in "front loading"of expenses related to the lease compared to the current model, which results in straight-line expense recognition in many instances.
During their recent meeting, the Boards' discussion focused on various approaches to a lessee's subsequent measurement of the ROU asset. Focusing on this issue is an attempt by the Boards to address concerns raised by some constituents that the front loading of expenses does not reflect the underlying economics of every type of lease. The Boards discussed three alternative approaches to subsequent measurement of the ROU asset: the original ED approach, an interest-based amortization approach, and an underlying asset approach.
Under the original ED approach, a lease contract would be treated similar to the purchase of a nonfinancial asset that is financed separately. The ROU asset would be amortized in a manner consistent with other nonfinancial assets, and the lease liability would be accounted for as a financial liability (using the effective interest method). As previously indicated, this approach results in front-loading of total lease expense because the amount of interest expense recognized on the lease liability would be highest at the beginning of the lease and lowest at the end of the lease.
Under the interest-based amortization approach, a lease contract would be treated differently from the purchase of a nonfinancial asset that is financed separately. In other words, under this approach, lease contracts give rise to ROU assets, which would be a distinct class of nonfinancial assets that would be amortized differently from other nonfinancial assets. A lessee would subsequently measure the ROU asset at amortized cost at the present value of its remaining economic benefits, discounted using the discount rate used to initially measure the ROU asset. This approach would result in total lease expense being recognized more evenly than under the original ED approach because the lessee would consider the time value of money when subsequently measuring both the ROU asset and the lease liability. The amortization expense on the asset would typically be lower in the early years of a lease, offsetting the higher interest expense on the lease liability in those years. Conversely, the amortization expense on the asset would typically be higher in the later years of a lease, which would be offset by lower interest expense on the lease liability in those years. However, the interest-based amortization approach would not result in straight-line lease expense in every circumstance, and it would require the lessee to estimate the pattern of benefits under the lease (which may or may not be straight-line) for purposes of calculating the present value of the ROU asset at the beginning of each period.
Under the underlying asset approach, a lease contract would be treated as equivalent to the purchase of the underlying leased asset that is financed separately for a period equal to the lease term. Amortization of the ROU asset would be calculated as the sum of two components: (a) the amortization on the piece of the underlying asset expected to be consumed by the lessee over the lease term and (b) the unwinding of the discount on the expected value of the underlying asset at the end of the lease term (at the interest rate used to initially measure the ROU asset). To apply this approach, a lessee would need to determine the estimated decrease in the fair value of the asset that would occur during the lease. If the lessee expected greater consumption of the value of the leased asset, a more front-loaded expense recognition pattern would result. In contrast, a low level of expected consumption would result in an expense recognition pattern closer to straight line.
The majority of the discussion at the Boards’ recent meeting centered on the interest-based amortization approach and the underlying asset approach. The Boards were unable to come to a consensus on one approach. The IASB expressed a unanimous tentative preference for the underlying asset approach. However, a majority of the FASB tentatively indicated they would not accept that approach. Instead, there was some support amongst the FASB for classifying leases as operating or financing and having that classification determine the approach that would be used (i.e., the interest-based amortization approach would be used for operating leases, and the original ED approach would be used for financing leases). The Boards instructed their staffs to perform additional outreach and analysis of the alternative approaches. The analysis is expected to be discussed at the April 2012 meeting. As a result, a revised ED is not expected to be issued before the third quarter of 2012.