Proposed changes to Accounting for Leases

it pours and pours

What is the proposed change?
For lessees, FASB and IASB believe that all lease contracts should be treated in a manner similar to the treatment of finance leases. Thus removing the existing requirement for lessees to differentiate leases as finance or operating leases.

Why the proposed change?

  1. Firstly, current rules which determine lease classification may result in similar transactions reported very differently, leading to lack of comparability and significant amounts of off balance-sheet finance not being recognised.
  2. Secondly, the right obtained by the lessee in a lease contract is the right to use the leased asset during the lease term. This right meets the definition of an asset. The lessee incurs an obligation to pay rentals in a lease contract, and that this obligation meets the definition of a liability. (“Right of Use” model)

Details of proposed change for LESSEE under “Right of Use model”

  • Leases would be measured at cost initially ie.the present value of the lease payments, including initial direct costs incurred by the lessee.
  • Present values would be calculated using the lessee’s incremental borrowing rate as the discount rate.
  • Expense to lessee would be interest expense on instalments paid. (Existing treatment is rental expense.)

Possible consequences

For the lessees, interest expense would thus be higher in the early years of a lease (compared with the current straight-line treatment for rent expense) ==> impact on accounting ratios / loan covenants / profitability / credit ratings and other external measures of financial

For the lessors, a significant chunk of their business could disappear overnight if the lessees decide to buy the assets themselves instead trying to rent.

Source – Accounting and Business Singapore 06/2010

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One Comment

  1. Ephraim Seow of today's Today reported that PWC estimated that about $22billion worth of operating leases or liabilities are kept the balance sheet by 20 largest firms in terms of market capitalisation as of July 31.Consequently the changes will raise a company's reported debt load by 58%.Should we not consider the debit side of accounting entries too? We seems to make such a big hoo haa about the credit side effect.

    Reply

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