Accounting for leases in the United States
Accounting for leases in the United States is 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 finalization of new standards is expected in late 2014.
A lease is a contract 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.
Accounting for leases by the lessee
The accounting profession recognizes leases as either an operating lease or a capital lease (finance lease). An operating lease records no asset or liability on the financial statements, 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 statements, 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 2014. The basic criteria for capitalization of a lease by lessee are as follows:
- The lessor transfers ownership of the asset to the lessee at the end of the lease term.
- A bargain 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 value 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 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.
Under an operating lease, the lessee records rent expense (debit) 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 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 contract 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.
Under an operating lease, the lessor records rent revenue (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. If the rent changes over the life of the lease, normally the rental income is recognized on a straight-line basis (also known as rent leveling), and the difference between income and cash received is recorded as a deferred asset or liability (mirroring lessee accounting).
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. If the cost or carrying amount of the asset being leased is different from its fair value at inception, then the difference is recognized as a profit and the lease is called a sales-type lease. This most commonly applies when a manufacturer is using leasing as a method of selling its product. Other capital lessor leases, where the cost and fair value are the same, are called direct financing leases.
Usually, when a lease is entered into, a security 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.
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] / [Total amount out of pocket] = Annual Lease Rate
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. These changes will increase transparency within the rules and prevent a loophole that allows for off-balance-sheet financing through leases.
The project commenced in 2006. The targeted completion date has been extended several times, and is now late 2014. 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 on 16 May 2013, with a public comment period open until 13 September 2013
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 2017 is now considered the likely effective date. However, companies will be required to restate comparable years in their annual reports. Most U.S. companies include two years of comparables in their annual report, so the new standard would be implemented as of 2015.
Present vs. New Lease Accounting Standards
The Preliminary Views and first Exposure Draft called for eliminating the FAS 13 test which classifies leases as operating leases or capital leases, and treating all leases similarly to current capital leases. Unlike current lease accounting standards, all leases would 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. Following substantial protests from both financial statements preparers and users, the second Exposure Draft reinstated two types of lease accounting, with "Type A" leases treated essentially the same as FAS 13 capital leases and "Type B" leases maintaining the single lease expense, straight line over the life of the lease, that characterizes FAS 13 operating leases, but with an asset and liability on the balance sheet. The liability would be the present value of the remaining rents; the asset would be the same as the liability for simple leases, but then adjusted for scheduled changes in rents (which under FAS 13 result in a deferred rent liability or asset) and amortization of initial direct costs. Effective with the second Exposure Draft, the new standard has been given the new Accounting Standards Codification topic number 842 (the topic number for leases was previously 840).
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.
- FASB Current Technical Plan and Project Updates, retrieved 3/16/2012
- Stickney and Weil 2007 p. 791 (Glossary of Financial Accounting: An Intro. to Concepts, Methods, and Use 12e).
- 34 Am. Jur. 2d Federal Taxation ¶ 16762 Section 467 rental agreements defined: “A rental agreement includes any written or oral agreement that provides for the use of tangible property and is treated as a lease for federal income tax purposes."
- FASB Project Update: Leases
- IASB Current Projects: Leases
- FASB Technical Bulletin 85-3
- Letter from SEC Chief Accountant, Feb. 7, 2005
- A Roadmap for Convergence between IFRSs and US GAAP – 2006-2008: Memorandum of Understanding between the FASB and IASB, International Accounting Standards Board, February 27, 2006
- Completing the February 2006 Memorandum of Understanding - A progress report and timetable for completion, Financial Accounting Standards Board, September 11, 2008
- "FASB Formally Adds Project to Reconsider Lease Accounting" (Press release). Financial Accounting Standards Board. July 19, 2006. Retrieved January 19, 2011.
- Financial Accounting Standards Board. "FASB: Financial Accounting Standards Board". Archived from the original on 5 January 2011. Retrieved January 19, 2011.
- Proposed Accounting Standards Update: Leases (Topic 840), Financial Accounting Standards Board, August 17, 2010
- Proposed Accounting Standards Update: Leases (Topic 842): a revision of the 2010 proposed FASB Accounting Standards Update, Leases (Topic 840), Financial Accounting Standards Board, May 16, 2013
- The New Lease Accounting Standard and You, TRIRIGA Inc., July 2010