Thus, FASB and IASB began working together to improve the accounting for lease rights and obligations. FASB issued a proposed standards update, Leases (Topic 842), which is a revision to Leases (Topic 840). This document is considered a revised Exposure Draft (ED) and would require assets and liabilities arising from leases to be recognized on the balance sheet. Thus, the new standards will provide more transparency and disclose key information. The main objective is that a company should recognize assets and liabilities that result from a lease. A lessee would recognize assets and liabilities for a maximum term of more than 12 months. FASB indicates, “The recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee would depend primarily on whether the lessee is expected to consume more than an insignificant portion of the economic benefits embedded in the underlying asset.”
In the United States under current accounting standards, leases are characterized as either operating or capital. In the United States under current accounting standards, leases are characterized as either operating or capital. With an operating lease, rent expenses are written off in the year they occur and appear on the organization's income statement as an operating expense to arrive at net operating income. The income statement more or less reflects cash flow. Under the proposed changes, all leases would be treated as capital leases. Understanding why this change is significant requires some background.
Also, the revised ED sets forth standards for lease classification. The principle for the lease classification for determining between two lease types would be based on the portion of the economic benefits of the underlying asset expected to be consumed by the lessee over the lease term. Ernst and Young’s article “Leases Re-exposed: Another Attempt at Improving Lease Accounting” breaks out the classification of leases as follows:
Leases of assets that are not property (e.g., equipment, vehicles) would be classified as Type A leases unless one of the following two criteria is met:
The lease term is for an insignificant part of the total economic life of the underlying asset
The present value of the lease payments is insignificant relative to the fair value of the underlying asset
Leases of property (i.e., land, a building or part of a building) would be classified as Type B leases, unless one of the following two criteria is met:
The lease term is for the major part of the remaining economic life of the underlying asset
The present value of the lease payments accounts for substantially all of the fair value of the underlying asset
The article then details that under the revised ED, Type A leases would cause accelerated