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reporting of capital and operating leases and their impact on fair value measurements. The essay surveys lease accounting standards from 1976 thru the present.
The basic principle of lease accounting is that some leases are merely rentals, while others are in effect purchases. U.S. regulations that specify lease accounting rules are issued by the Financial Accounting Standards Board (FASB). The primary FASB statement on leases was Number 13, issued in 1976, and is also known as FAS 13, SFAS 13 and FASB 13. Over the years it has been amended several times by additional FAS, including FAS 22, FAS 23, FAS 27, FAS 28, FAS 29, FAS 98, and FAS 121. In addition to financial accounting standards, various interpretations and technical bulletins have also been issued to provide additional guidance. Lease accounting rules were previously labeled as section L10 in the FASB Current Text, while the new FASB Codification uses section ASC 840 for lease accounting rules and guidelines ("Lease Accounting Rules").
The AICPA also publishes leasing accounting guidelines. In 1962 the AICPA published Accounting Research Study (ARS) No. 4, Reporting of Leases in Financial Statements, which re-examined the treatment of leasing and its development since the late 1940. The study's author, John H. Myers, argued that since the issuance of ARB 38, as well as its restatement in ARB 43, leases had grown in importance. Myers also contended that disclosures were rarely meeting ARB 43 standards, that financial analysts were seeking more information than that required by ARB 43, and that balance sheet presentation of leases that were in substance purchases was nearly non-existent ("History" 3).
Myers presented a series of examples illustrating how leases can vary from a clear in-substance ownership and mortgage-borrowing arrangement to a more traditional rent arrangement. Myers therefore introduced a different accounting model from that used in ARB 43. Instead of considering how closely a lease corresponded to an ownership and mortgage-borrowing arrangement, Myers argued that a lease conveys rights to use property, even if those rights are not perfectly aligned with or even close to ownership rights. As a result, the rights obtained through a lease could still be considered an asset, even if the lease term was for a relatively short duration ("History" 4).
The U.S. Securities and Exchange Commission (SEC) also establishes lease accounting standards as part of its mission to protect investors and maintain order in the markets. In October 1973, the SEC issued Accounting Series Release (ASR) No. 147, Notice of Adoption of Amendments to Regulation S-X Requiring Improved Disclosure of Lease. ASR 147 criticized the Accounting Principles Board for requiring substantially less disclosure in Opinion 31 than that which the SEC had identified as needed by investors. As a result, the SEC provided the most extensive recognition and disclosure requirements to date for lease accounting. By contrast with Opinion 31, the SEC required disclosure of the present value of financing leases as well as their impact on net income of capitalization of such leases. ASR 147 also included other lease accounting guidance which covered renewal options, determining whether a lessor's investment was recovered, fair market value of leased assets, minimum rentals, net lease payments, implicit interest rates, and materiality ("History" 11).
One aspect of lease accounting that ASR 147 did not address was providing any new conceptual model for lease accounting. However, it did define a financing lease to be "…a lease which, during the non-cancelable lease period, either (i) covers 75% or more of the economic life of the property or (ii) has terms which assure the lessor a full recovery of the fair market value & #8230; of the property at the inception of the lease…(ASR 147, Sec.C." These criteria were roughly equivalent to those listed in Opinion 27, except that the SEC substituted the 75% test for the substantially-equal-to-the-remaining-useful-life test. ASR 147 did not provide any new rationale or models to justify the recognition or disclosure of lease arrangements ("History" 11).
In November 1976, the FASB issued Statement No. 13, Accounting for Leases, which provided for only minor changes to the 1976 Exposure Draft. The implemental and conceptual grounding issues that had been previously discussed remained virtually unchanged in this standard. No additional developments in the definitions of assets or liabilities were explicitly referenced in the new standard ("History" 18).
The IASB and FASB provided the following summary of lease accounting standards and studies over a 50-year period, from 1949-1999:
History of Lease Accounting
Source: History of Lease Accounting (Agenda Paper 2)
The FASB acknowledges leasing as an important source of finance, and is therefore appropriately concerned with the impact of lease accounting rules, the subject of a Proposed Accounting Standards Update, Leases (Topic 840). For this reason, the FASB and other standards bodies continue to modify lease accounting to provide users of accounting statements with a full and understandable picture of an entity's leasing activities. Until recently, accounting models required that lessees classify their leases as either capital leases or operating leases. Neither of these models fully meet the needs of users of financial statements because they do not provide completely accurate representations of leasing transactions. Because of distinctions between capital leases and operating leases, the models also contribute to undue complexity and lack of comparability, causing many users to adjust amounts presented in the statement of financial position so as to accurately reflect the assets and liabilities arising from operating leases ("Leases" 1).
The FASB Exposure Draft of August 2010 proposes one set of leasing guidelines for both lessee accounting and lessor accounting, with the proposed guidelines affecting any entity that enters into a lease, with the exception of some specified exemptions. The proposed requirements would supersede U.S. GAAP and International Accounting Standards (IAS) 17, "Leases" in International Financial Reporting Standards (IFRSs). The Exposure Draft proposes that lessees and lessors should apply a right-of-use model in accounting for leases. This model applies to right-of-use assets in a sublease as well. This model does not apply to leases of biological and intangible assets, nor does it apply to leases to explore for or use natural resources and leases of some investment properties ("Leases" 2).
If the 2010 FASB Exposure Draft is confirmed, the result would cause significant changes in the accounting requirements for both lessees as well as lessors. Lessees that would be most affected by the confirmation of the exposure draft are those with a significant portfolio of assets held under operating leases, particularly those with leases of property. Currently U.S. GAAP and IFRSs, lease payments that arise from operating leases are recognized in the period in which they occur. The proposed standards would require lessees to recognize the assets and liabilities arising from those leases ("Leases" 3).
While the proposed changes may be less fundamental for leases that are currently classified as capital leases, they would nonetheless result in significant changes in the measurements of the assets and liabilities arising from those leases because of the manner that the exposure draft proposes to account for options and contingent rentals. Also, the proposed changes would significantly affect the pattern of income and expense recognition in the income statement ("Leases" 3).
Lessor accounting would change significantly from existing U.S. GAAP and IFRSs. The results would depend on the extent to which a lessor retains exposure to risks or benefits that are associated with the underlying asset. The lessor would apply either a performance obligation approach or a de-recognition approach. No separate approach would be proposed for leveraged leases ("Leases" 3).
For the scenario where a lessor retains exposure to significant risks or benefits associated with the underlying asset, the lessor would continue to recognize the underlying asset and, in addition, would recognize a right to receive lease payments and a lease liability. The lessor would then be viewed as satisfying the lease liability continuously over the term of the lease, and would therefore recognize lease income continuously over the term of the lease ("Leases" 3).
In the event a lessor does not retain exposure to significant risks or benefits associated with the underlying asset, then the lease would be accounted for in a way that is similar to current accounting for capital leases. The resulting pattern of income recognition is similar to the pattern of revenue recognition that is currently required for manufacturer/dealer lessors. However, significant changes would occur in the measurement of the right to receive lease payments, the recognition of lease income as well as the recognition and measurement of residual assets. For these leases, the lessor would satisfy the lease liability at the date of commencement of the lease by delivering the right-of-use asset to the lessee and, in doing so, would recognize lease income representing the sale of the right to use the underlying asset. ("Leases" 4).
The 2010 FASB Exposure Draft also asks for comments on a range of lease accounting topics. In addition, it proposes the following definition of a lease: "a contract in which the right to use a specified asset or assets is conveyed,…[continue]
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