Accounting for leases in the United States
Encyclopedia
Accounting for leases in the United States regulated by the Financial Accounting Standards Board
(FASB) by the Financial Accounting Standards Number 13. These standards were effective as of January 1, 1977. These standards are currently under discussion for changes in FASB Topic 840, and implementation of new standards is not expected before 2012.
calling for the lessee (user) to pay the lessor (owner) for use of an asset for a specified period of time. A rental agreement is a lease in which the asset is tangible property
. As there are many ways to view how these contracts affect the balance sheets of both the lessee and lessor, FASB created a standard for US accountants and businesses.
or a capital lease
(finance lease). An operating lease records no asset or liability on the financial statement
s, the amount paid is expensed as incurred. On the other hand, a capital lease is recorded as both an asset and a liability on the financial statement
s, generally at the present value of the rental payments (but never greater than the asset's fair market value). To distinguish the two, the Financial Accounting Standards Board
(FASB) provided criteria for when a lease should be capitalized, and if any one of the criteria for capitalization is met, the lease is treated as a capital lease and recorded on the financial statements
. The primary standard for lease accounting is Statement of Financial Accounting Standards No. 13 (FAS 13), which has been amended several times; it is known as topic 840 in the FASB's new Accounting Standards Codification. In July 2006, the FASB and the International Accounting Standards Board
(IASB) announced the commencement of a joint project to comprehensively reconsider lease accounting. The boards' stated intention is to recognize an asset and obligation for all leases (in essence, making all leases capital leases). The projected completion of the project is now late 2011.
The basic criteria for capitalization of a lease by lessee are as follows:
These are called the 7(a)-7(d) tests, named for the paragraphs of FAS 13 in which they are found.
If any of the above are met, the lease would be considered a capital or financing lease and must be disclosed on the lessee's balance sheet. Conversely, if none of the criteria are met, the contract is an operating lease, and the lessee will have a footnote in its balance sheet to that effect. Both parties (lessor and lessee) must review these criteria at the outset and determine independently the classification as it is possible to classify them differently (it is quite common, in fact, for a single lease to be considered a capital lease by lessors and an operating lease by lessees).
If the term of the lease does not exceed 12 months, the lease may be considered neither of the above criteria. These contracts are "rentals" and do not need to be disclosed in lessee's footnotes.
For a more in depth explanation, see the accounting textbook Intermediate Accounting, 11th ed, Kieso Weygandt Warfield.
) over the lease term, and a credit to either cash or rent payable. If an operating lease has scheduled changes in rent, normally the rent must be expensed on a straight-line basis over its life, with a deferred liability or asset reported on the balance sheet for the difference between expense and cash outlay.
Under a capital lease, the lessee does not record rent as an expense. Instead, the rent is reclassified as interest and obligation payments, similarly to a mortgage (with the interest calculated each rental period on the outstanding obligation balance). At the same time, the asset is depreciated. If the lease has an ownership transfer or bargain purchase option, the depreciable life is the asset's economic life; otherwise, the depreciable life is the lease term. Over the life of the lease, the interest and depreciation combined will be equal to the rent payments.
For both capital and operating leases, a separate footnote to the financial statements discloses the future minimum rental commitments, by year for the next five years, then all remaining years as a group.
Other lessee financial accounting issues:
Under a capital lease, the lessor credits owned assets and debits a lease receivable account for the present value of the rents (an asset, which is broken out between current and long-term, the latter being the present value of rents due more than 12 months in the future). With each payment, cash is debited, the receivable is credited, and unearned (interest) income is credited.
deposit is required. There are two types of security deposits:
[Monthly Lease Payment] x [Term (months)] = [Total amount out of pocket]
[Total amount out of pocket] - [Financed amount] = [Total finance charge]
[Total finance charge] / [Term (years)] = [Finance charge per year]
[Finance charges per year] / [Financed amount] = Annual Lease Rate
that allows for off-balance-sheet
financing through leases.
Other critical dates within the project include;
The Effective Date of the new standard - date at which time all companies must follow the new lease accounting standard when preparing financial statements –may not be known until the final rule is issued, but many expect that 2013 will be the first year that companies will be required to report their real estate and equipment leases as assets on their balance sheets.
While the first Exposure Draft envisioned including likely rent (contingent rents and options to renew) in addition to minimum required rent payments, subsequent decisions by the boards have reversed these plans, making the proposed accounting for lessees similar to that of existing capital leases. Lessor accounting will be similar to current direct finance lease accounting, though with the potential for recognizing a profit at the beginning of the lease term in certain circumstances. Leases with a maximum term of 12 months or less would be treated in accordance with current operating lease rules.
Project Update on Topic 840
FASB Topic 840 Documentation
Financial Accounting Standards Board
The Financial Accounting Standards Board is a private, not-for-profit organization whose primary purpose is to develop generally accepted accounting principles within the United States in the public's interest...
(FASB) by the Financial Accounting Standards Number 13. These standards were effective as of January 1, 1977. These standards are currently under discussion for changes in FASB Topic 840, and implementation of new standards is not expected before 2012.
Introduction
A lease is a contractContract
A contract is an agreement entered into by two parties or more with the intention of creating a legal obligation, which may have elements in writing. Contracts can be made orally. The remedy for breach of contract can be "damages" or compensation of money. In equity, the remedy can be specific...
calling for the lessee (user) to pay the lessor (owner) for use of an asset for a specified period of time. A rental agreement is a lease in which the asset is tangible property
Tangible property
Tangible property in law is, literally, anything which can be touched, and includes both real property and personal property , and stands in distinction to intangible property....
. As there are many ways to view how these contracts affect the balance sheets of both the lessee and lessor, FASB created a standard for US accountants and businesses.
Accounting for leases by the lessee
The accounting profession recognizes leases as either an operating leaseOperating leasing
An operating lease is a lease whose term is short compared to the useful life of the asset or piece of equipment being leased. An operating lease is commonly used to acquire equipment on a relatively short-term basis...
or a capital lease
Finance lease
A finance lease or capital lease is a type of lease. It is a commercial arrangement where:* the lessee will select an asset ;* the lessor will purchase that asset;...
(finance lease). An operating lease records no asset or liability on the financial statement
Financial statement
A financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...
s, the amount paid is expensed as incurred. On the other hand, a capital lease is recorded as both an asset and a liability on the financial statement
Financial statement
A financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...
s, generally at the present value of the rental payments (but never greater than the asset's fair market value). To distinguish the two, the Financial Accounting Standards Board
Financial Accounting Standards Board
The Financial Accounting Standards Board is a private, not-for-profit organization whose primary purpose is to develop generally accepted accounting principles within the United States in the public's interest...
(FASB) provided criteria for when a lease should be capitalized, and if any one of the criteria for capitalization is met, the lease is treated as a capital lease and recorded on the financial statements
Financial statements
A financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...
. The primary standard for lease accounting is Statement of Financial Accounting Standards No. 13 (FAS 13), which has been amended several times; it is known as topic 840 in the FASB's new Accounting Standards Codification. In July 2006, the FASB and the International Accounting Standards Board
International Accounting Standards Board
The International Accounting Standards Board is an independent, privately funded accounting standard-setter based in London, England.The IASB was founded on April 1, 2001 as the successor to the International Accounting Standards Committee...
(IASB) announced the commencement of a joint project to comprehensively reconsider lease accounting. The boards' stated intention is to recognize an asset and obligation for all leases (in essence, making all leases capital leases). The projected completion of the project is now late 2011.
The basic criteria for capitalization of a lease by lessee are as follows:
- The lessor transfers ownershipOwnershipOwnership is the state or fact of exclusive rights and control over property, which may be an object, land/real estate or intellectual property. Ownership involves multiple rights, collectively referred to as title, which may be separated and held by different parties. The concept of ownership has...
of the assetAssetIn financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
to the lessee at the end of the lease term. - A bargainBargainBargain could mean some of the following:* The process whereby buyer and seller agree the price of goods or services. See bargaining.* An agreement to exchange goods at a price.* Such an agreement where one of the parties thinks the price is very favourable....
purchase option is given to the lessee. This is an option that allows the lessee, upon termination of the lease, to purchase the leased asset at a price significantly lower than the expected fair market valueFair market valueFair market value is an estimate of the market value of a property, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market. An estimate of fair market value may be founded either on precedent or...
of the asset. - The life of the lease is equal to or greater than 75% of the economic life of the asset.
- The present value of the minimum lease payments (MLP) is equal to or greater than 90% of the fair market value of leased property. To understand and apply this criterion, you need familiarize yourself with what is included in the minimum lease payments and how the present value is calculated. The minimum lease payments include the minimum rental payments minus any executory cost, the guaranteed residual valueResidual valueResidual value is one of the constituents of a leasing calculus or operation. It describes the future value of a good in terms of percentage of depreciation of its initial value....
, the bargain purchase option, and any penalty for failure to renew or extend the lease. The amount calculated is then discounted using the lessee’s incremental borrowing rate. However, if the lessee knows the implicit rate used by the lessor and the rate is less than the lessee’s rate, the lessee should use the lessor’s rate to discount the minimum lease payment.
These are called the 7(a)-7(d) tests, named for the paragraphs of FAS 13 in which they are found.
If any of the above are met, the lease would be considered a capital or financing lease and must be disclosed on the lessee's balance sheet. Conversely, if none of the criteria are met, the contract is an operating lease, and the lessee will have a footnote in its balance sheet to that effect. Both parties (lessor and lessee) must review these criteria at the outset and determine independently the classification as it is possible to classify them differently (it is quite common, in fact, for a single lease to be considered a capital lease by lessors and an operating lease by lessees).
If the term of the lease does not exceed 12 months, the lease may be considered neither of the above criteria. These contracts are "rentals" and do not need to be disclosed in lessee's footnotes.
For a more in depth explanation, see the accounting textbook Intermediate Accounting, 11th ed, Kieso Weygandt Warfield.
Lessee Accounting
Under an operating lease, the lessee records rent expense (debitDebit
Debit and credit are the two aspects of every financial transaction. Their use and implication is the fundamental concept in the double-entry bookkeeping system, in which every debit transaction must have a corresponding credit transaction and vice versa.Debits and credits are a system of notation...
) over the lease term, and a credit to either cash or rent payable. If an operating lease has scheduled changes in rent, normally the rent must be expensed on a straight-line basis over its life, with a deferred liability or asset reported on the balance sheet for the difference between expense and cash outlay.
Under a capital lease, the lessee does not record rent as an expense. Instead, the rent is reclassified as interest and obligation payments, similarly to a mortgage (with the interest calculated each rental period on the outstanding obligation balance). At the same time, the asset is depreciated. If the lease has an ownership transfer or bargain purchase option, the depreciable life is the asset's economic life; otherwise, the depreciable life is the lease term. Over the life of the lease, the interest and depreciation combined will be equal to the rent payments.
For both capital and operating leases, a separate footnote to the financial statements discloses the future minimum rental commitments, by year for the next five years, then all remaining years as a group.
Other lessee financial accounting issues:
- Leasehold Improvements: Improvements made by the lessee. These are permanently affixed to the property, and revert back to the lessor at the termination of the lease. The value of the leasehold improvements should be capitalized and depreciated over the lesser of the lease life or the leasehold improvements life. If the life of the leasehold improvement extends past the life of the initial term of the lease and into an option period, normally that option period must be considered part of the life of the lease.
- Lease Bonus: Prepayment for future expenses. Classified as an asset; amortized using the straight-line method over the life of the lease.
- Rent Kicker, or Percentage Rent: Common in retail store leases. This is a premium rent payment that the lessor requires and is treated as a period expense. For example, it may be stated in the contractContractA contract is an agreement entered into by two parties or more with the intention of creating a legal obligation, which may have elements in writing. Contracts can be made orally. The remedy for breach of contract can be "damages" or compensation of money. In equity, the remedy can be specific...
that if sales are over $1,000,000, any excess over this amount will have 2% taken out as a rent kicker. This is not reported as part of the future minimum rental commitments disclosure, nor in the 7(d) test to determine whether the lease is capital or operating.
Lessor Accounting
dits|credit]]) and a corresponding debit to either cash/rent receivable. The asset remains on the lessor's books as an owned asset, and the lessor records depreciation expense over the life of the asset.Under a capital lease, the lessor credits owned assets and debits a lease receivable account for the present value of the rents (an asset, which is broken out between current and long-term, the latter being the present value of rents due more than 12 months in the future). With each payment, cash is debited, the receivable is credited, and unearned (interest) income is credited.
Other Issues
Usually, when a lease is entered into, a securitySecurity
Security is the degree of protection against danger, damage, loss, and crime. Security as a form of protection are structures and processes that provide or improve security as a condition. The Institute for Security and Open Methodologies in the OSSTMM 3 defines security as "a form of protection...
deposit is required. There are two types of security deposits:
- Nonrefundable security deposits: Deferred by the lessor as unearned revenue; Capitalized by the lessee as a prepaid rent expense until the lessor considers the deposit earned.
- Refundable security deposits: Treated as a receivable by the lessee; Treated as a liability by the lessor until the deposit is refunded to the lessee.
Calculation
How to calculate the lease rate:[Monthly Lease Payment] x [Term (months)] = [Total amount out of pocket]
[Total amount out of pocket] - [Financed amount] = [Total finance charge]
[Total finance charge] / [Term (years)] = [Finance charge per year]
[Finance charges per year] / [Financed amount] = Annual Lease Rate
Changes under discussion
Currently, there are several changes being discussed by FASB and the accountant community over lease accounting in the United States. These changes will increase transparency within the rules and prevent a loopholeLoophole
A loophole is a weakness that allows a system to be circumvented.Loophole may also refer to:*Arrowslit, a slit in a castle wall*Loophole , a short science fiction story by Arthur C...
that allows for off-balance-sheet
Off-balance-sheet
Off-balance sheet usually means an asset or debt or financing activity not on the company's balance sheet.Some companies may have significant amounts of off-balance sheet assets and liabilities. For example, financial institutions often offer asset management or brokerage services to their clients...
financing through leases.
Lease Accounting Rule Changes
As part of their joint commitment to the “development of high quality, compatible accounting standards that could be used for both domestic and cross-border financial reporting”, the IASB and the FASB agreed to priorities and milestones for convergence of lease accounting rules by 2011. The project goal, “to insure that investors and other users of financial statements are provided useful, transparent, and complete information about leasing transactions in the financial statements”, reflects investor concerns that current accounting standards fail to clearly portray the resources and obligations from leases in a complete and transparent manner.Project Timeline
The project commenced in 2006. The targeted completion date has been extended several times, and is now late 2011.Other critical dates within the project include;
- issuance of a Discussion Paper - Leases: Preliminary Views - on 19 March 2009 with a public comment period open until 17 July 2009
- Issuance of joint Exposure Drafts on 17 August 2010 with a public comment period open until 15 December 2010
- Issuance of a second joint Exposure Draft: announced on 21 July 2011, to be released during Q3 2011.
The Effective Date of the new standard - date at which time all companies must follow the new lease accounting standard when preparing financial statements –may not be known until the final rule is issued, but many expect that 2013 will be the first year that companies will be required to report their real estate and equipment leases as assets on their balance sheets.
Present vs. New Lease Accounting Standards
The proposed lease accounting rules eliminate the FAS 13 test which classifies leases as operating leases or capital leases. Unlike current lease accounting standards, all leases will be accounted for as assets and liabilities on the balance sheet – on the asset side as ‘right-to-use-assets’ and on the liability side as lease liabilities.While the first Exposure Draft envisioned including likely rent (contingent rents and options to renew) in addition to minimum required rent payments, subsequent decisions by the boards have reversed these plans, making the proposed accounting for lessees similar to that of existing capital leases. Lessor accounting will be similar to current direct finance lease accounting, though with the potential for recognizing a profit at the beginning of the lease term in certain circumstances. Leases with a maximum term of 12 months or less would be treated in accordance with current operating lease rules.
Impact of New Lease Accounting Rules
According to the U.S. Securities and Exchange Commission (SEC), the financial impact of the proposed lease accounting rule changes is estimated to add more than $1.3 trillion of operating lease obligations to corporate balance sheets. This will have a profound and lasting effect on the financial and real estate strategies and processes of global companies as real property leases are very large for many companies.See also
Documentation for FAS 13Project Update on Topic 840
FASB Topic 840 Documentation