LEASE ACCOUNTING CHANGE EXAMPLE

By | April 1, 2011

LEASE ACCOUNTING CHANGE EXAMPLE

iLease Management LLC monitors and reports on the progress of the proposed changes to lease accounting.  The FASB and the IASB issued an Exposure Draft in 2010 which generated a significant amount of controversy among preparers and users of financial statements. The Boards continue to meet to evaluate the more contentious issues and are considering changes to the Boards’ original proposal, particularly in such areas as lease renewal options and contingent rents.  Included is a simplified example of how we expect the current changes to impact the accounting process and reporting for a basic real estate lease.  This example does not take into account many of the more complex and subjective areas of the original Exposure Draft dealing with subjects such as lease renewal options, contingent rents, residual value guarantees and term option penalties.    

To illustrate the impact of the proposed new lease accounting model for lessees, consider the following example:

Assumptions

  1. A four-year non-cancelable lease term:  48 months
  2. Minimum monthly lease payment:  $1,000
    1. Assuming there are no defined lease options, contingent rental payments or residual value guarantee
    2. Incremental borrowing rate:  7%

Calculated Amounts

Present Value (PV) of lease payments = $42,000

Total lease payments over the 48 month term = $48,000

Balance sheet analysis

Under current GAAP Accounting for an operating lease where rent is accounted for in the current period

Existing US GAAP
  At inception End of Yr 1 End of Yr 2 End of Yr 3 End of Lease Term
No asset $0 0 0 0 0
No liability $0 0 0 0 0

 

Under the proposed guidelines, there is an increase in assets and liabilities.

Proposed Model
  At inception End of Yr 1 End of Yr 2 End of Yr 3 End of Lease Term
Assets          
Right To Use Asset $42,000 31,500 21,000 10,500 0
Liabilities          
Rent Payable $42,000 32,600 22,450 11,600 0

 

Profit and loss statement expense analysis

Under the proposed model, the right to use asset is amortized to expense over the term of the lease and the rent payable liability decreases as rental payments are made. 

  Year 1 Year 2 Year 3 Year 4
Existing US GAAP        
Rental Expense                                       $12,000 12,000 12,000 12,000
         
Proposed model        
         
Amortization of Right To Use Asset $10,500 10,500 10,500 10,500
Interest Expense $2,600 1,850 1,150 400
Proposed Expense $13,100 12,350 11,650 10,900

 

Accounting entries under the proposed model would be as follows:

  Debit Credit
Accounting by lessee – at inception    
     
Right To Use Asset $42,000  
Rent Payable                                           $42,000
     
Accounting by lessee – year 1    
     
Amortization Expense $10,500  
Right To Use Asset   $10,500
     
Interest Expense $2,600  
Rent Payable   $2,600
     
Rent Payable $12,000  
Cash   $12,000

 

In the profit and loss statement, rental expense under existing US GAAP becomes a combination of amortization and interest expense under the proposed model. Expense under the proposed model is higher in the earlier years of the term of the lease due to interest expense calculated using the effective interest method applied to a declining outstanding balance of rent payable.

In addition to the reporting changes to the balance sheet and P&L report identified above, firms should evaluate the impact to;

  • Current accounting processes
    • Lease Accounting system/software
    • Income tax impact
    • Financial Ratios
      • Increase in EBITDA
      • Return on Assets
      • Debt-to-Equity
      • Interest Coverage
      • Operating Margins
      • Debt covenant compliance
      • Ability to secure financing
      • Integrity of lease information
      • Resources required  

iLease Management LLC will continue to closely monitor and report on the decisions of the FASB/IASB Board meetings on the lease accounting changes.