Lease Accounting Standards: Evolution from FAS 13 to IFRS

Introduction to Lease Accounting Principles

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 standards, 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 FASB Codification uses section ASC 840 for lease accounting rules and guidelines ("Lease Accounting Rules").

The AICPA also publishes lease 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 1940s. 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 ARB 43 required, and that balance sheet presentation of leases that were in substance purchases was nearly non-existent ("History" 3).

Early Standards: AICPA, SEC, and the Road to FAS 13

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 rental 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 the SEC had identified as necessary for investors. As a result, the SEC provided the most extensive recognition and disclosure requirements to date for lease accounting. In contrast to Opinion 31, the SEC required disclosure of the present value of financing leases as well as their impact on net income from capitalization of such leases. ASR 147 also included guidance covering 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 the provision of a new conceptual model for lease accounting. However, it did define a financing lease as "a lease which, during the non-cancelable lease period, either (i) covers 75 percent 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 . . . 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 percent 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).

FASB Statement No. 13 and the 50-Year Historical Overview

The IASB and FASB provided a comprehensive summary of lease accounting standards and studies over a 50-year period, from 1949 to 1999, documenting the historical progression of lease accounting requirements across major standard-setting bodies.

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 financial 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 meets the needs of users of financial statements because they do not provide completely accurate representations of leasing transactions. Because of the 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 in order to accurately reflect the assets and liabilities arising from operating leases ("Leases" 1).

The 2010 FASB Exposure Draft and the Right-of-Use Model

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 certain specified exemptions. The proposed requirements would supersede U.S. GAAP and International Accounting Standard (IAS) 17, "Leases" within 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. It does not apply to leases of biological and intangible assets, nor does it apply to leases to explore for or use natural resources or to leases of certain investment properties ("Leases" 2).

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, for a period of time, in exchange for consideration . . . This exposure draft also proposes guidance on distinguishing between a lease and a contract that represents a purchase or sale . . . and on distinguishing a lease from a service contract" ("Leases" 6).

Conclusion

In summary, lease accounting standards have been and continue to be evolving to address the concerns associated with earlier standards and guidelines.