New Lease Standards

A lease is defined as an agreement between the owner of the asset (lessor) and the customer (lessee) where the customer is given the right to use an asset for an agreed period in exchange for consideration. The consideration may either be in the form of cash or non-cash. In a lease agreement, the customer decides how to use the asset leased to him. This implies that a customer chooses what ventures he can undertake with the asset leased. The lease agreement also gives the client exclusivity in its use for the period that the customer has leased it. During the period of the contract, the owner of the asset cannot reclaim the asset. According to the new definition of leases a company would be required to account separately for each lease component contained in the lease contract.

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Under the new IFRS (International Financial Reporting Standards) there are two classifications of leases that are leases of type A and those of type B.Type A leases are the leases in which the underlying asset is not property. Type A leases include interest income and expenses. This type of leases would be recognized in the same way they are currently recognized in the in the existing financial standards. On the other hand, B-type leases are property leases; they include land and buildings. Straight line income and expense recognition would be used for property leases.

In accounting for leases, the lessee would recognize the right to use an asset as the guiding factor to acknowledge the lease liability on the balance sheet. For a lessee to make lease payments on the leasing of an asset to him, he must of necessity have an exclusive right to use the asset as he deems beneficial to him. For both type A assets and B type assets the lease liability would be amortized using the effective interest rate method. The difference would be that type A assets would be generally amortized on a straight-line basis whereas in Type B assets the amortization would be done by measuring the right of use of an asset excluding any contingent rental expenses.

The value obtained by the right of use (ROU) of the lease is then used as a balancing figure to obtain a straight line profile of the total lease of the property asset which contains the interest expense and the amortization. In non-property leases, the lessor would recognize the residual asset (the value of asset obtained after deducting amortization) and a lease receivable on the balance sheet. The lesser would also derecognize the underlying asset. In accounting for property assets, the lessee will continue to recognize lease payments as income while continuing to recognize the underlying asset (the asset leased by the lessee). Short-term Leases (Leases that are less than 12 months)will be exempted from lease recognition and accounting. Small ticket leases (leases of a low value) are also exempted.

According to the FASB (Financial Accounting Standard Board), the lease liability will be equal to the present value of all lease payments made. Recognition of the leased asset will be anchored to the net value of the liability (value obtained after deducting the initial costs).In preparing the income statement, a dual model was used by the FASB.In the dual model, leases are categorized as either operating leases or financial leases. The classification of these leases will be based on the criteria used in the current standards for classifying leases in the current standard.Finance leases will result in a pattern where most expenses are incurred up front (front loaded pattern).This accounting is similar to that applied in the current accounting for capital leases. In accounting for operating leases, expenses are recognized in a straight line; expenses are distributed evenly over the period of the lease. This is the method used to recognize expenses in the current standards governing operating expenses.

The difference between the current standards for recognizing leases and the proposed standards is that in the proposed standards, there are changes in the definition of a lease; initial direct costs have been incorporated in recognizing a lease. This has been done to align lease accounting with the new revenue recognition standard. In the new standards leveraged leases as a type of a lease has been eliminated.

According to the new standards, operating leases should be presented differently from finance leases on the balance sheet. If the two leases are not presented differently, then there should be a distinction made in the Right of Use (ROU) notes. In presenting liabilities. The standards prohibit the presentation of operating leases and finance leases as a one line item. If these two items are not recorded on separate lines, then the lessee should include in the notes to the accounts which items include leases.

In presenting the cash flow statement, the FASB standards require that the company classify cash payments that arise from operating activities. Classification of cash payments for the principal portion of lease liability incurred in securing the lease should also be provided for. It also required that the cash payments made to the lessor for finance leases within operating activities to be provided for.

According to CFOs of General Electric (GE) and American International Group (AIG) the new standard will impact financial ratios used for benchmarking. Some of the ratios they expect to be affected will be a debt to equity ratio, return on asset ratio and the overall leverage on the balance sheet. The impact on these ratios will affect a number of gearing companies are able to get from lenders; as such it will be necessary to discuss these changes in advance with the lenders. The change in financial ratios will also affect investors as the ratios used to calculate the return on assets will also be affected. Fortune 500 companies are skeptical of the new standards as the cost implications of implementing these standards are not to implement the new standards.

References

Leases-Joint Project of the IASB and FASB. (2016). Fasb.org. Retrieved 6 March 2016, from HYPERLINK "http://www.fasb.org/jsp/FASB/FASBContent_C/ProjectUpdatePage&cid=900000011123" http://www.fasb.org/jsp/FASB/FASBContent_C/ProjectUpdatePage&cid=900000011123

Epstein, B. J., & Jermakowicz, E. K. (2008). Wiley IFRS 2008: Interpretation and application of international accounting and financial reporting standards 2008. Hoboken, N.J: Wiley.

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Sandretto, M. J. (2011). Cases in financial reporting. Mason, Ohio: South-Western.

Soares, C. (2016). In brief: Lease accounting: The long-awaited FASB standard has arrived. PwC. Retrieved 6 March 2016, from HYPERLINK "http://www.pwc.com/us/en/cfodirect/publications/in-brief/fasb-lease-accounting-standard-asc842.html" http://www.pwc.com/us/en/cfodirect/publications/in-brief/fasb-lease-accounting-standard-asc842.html

Stice, E. K., & Stice, J. D. (2012). Intermediate accounting. Mason, OH: South-Western/Cengage Learning.