Lease Standard Setting

Lease

Leases can be defined as the license to use to the property of equipment for a defined time span.
In the present scenario, the operating leases are off balance sheet items however, the new
guidance reflects on the operating leases with terms more than a year on the balance sheet with
the asset and liability that is similar to the capital lease today.
As per FASB 13, every lease can be classified either as operating or a capital leased but it
depends upon the particular criteria. Specifically, the majority of transactions in the present
scenario can be tagged as operating leases. An operating lease can be treated as a regular expense
while the operating lease can be treated as a financing transaction and hence must be reported as
an asset and liability on the financial statement of the company (Laux, 2014). The new standard
FASB 13 will ensure that all commercial real estate leases as capital lease instead of operating
lease. This reflects that the company is utilizing the GAAP and reporting of lease obligations on
the balance sheet as an asset and liability instead of treating it as an operating expense on the
income statement (Accounting for leases, 2018).
About the old standard FAS 13
The necessity of issuing original Standard on Leases (FAS 13)
The original Standard on Leases (FAS 13) was issued in the year 1976 namely “Accounting for
Leases”. Before its issuance, in the year 1949, it was determined by the Committee on
Accounting Procedures that to record long term leases, the operating lease accounting should not
be used. Hence a bulletin was issued namely “Disclosure of Long Term Leases in Financial
Statements of Lessors” in which it was required to classify the financial lease as leased assets
and liability. Under the GAAP rules, there was no requirement for capitalization of assets and
liability and thus most of the lessees used to report the transactions as off-balance sheet items. In
the later years, many changes were made to the existing rules by the Accounting Principles
Board wherein the reporting and accounting of finance leases were changed.
As there was no clarity in the accounting treatment of financial and operating leases, the Board
was asked to create a concise treatment or rules. Hence, the FASB board decided to issue a
precise standard namely FAS 13 –Accounting for Leases in the year 1976. Although in the later
years also there were numerous changes made in the standard.
Accounting Treatment of Leases under FAS 13

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Under old FAS 13- Accounting for Leases, the lease was classified into finance or capital lease
and operating lease. The standard also clarified the accounting and reporting treatment to be
done by both the lessor and the lessee. According to this standard, under the capital lease, the
assets taken on the lease had to be treated as an acquisition of assets also the liability had to be
shown on the liability side of the balance sheet. This way the capital leases were the only leases
shown in the balance sheet completely (Carlon, 2019).
In the books of lessors, there were three classifications under the finance lease- sales-type,
leveraged lease, and direct financing. These classifications were made in case the prescribed
criteria were fulfilled by the lease transaction to be a capital lease. 
The leases that did not fulfill the prescribed criteria were considered as an operating lease and the
leased asset was treated as property taken on rent. Leases other than capital lease were to be
shown as an operating lease. Under the operating lease, the lease expenses were shown as
operating expenses. In case of an operating lease, the lessee acquires the asset by paying a fee for
the remaining life of the asset like a vehicle, computer system, machinery, etc. The cost paid by
the lessee is claimed by him in the Income Statement as an expense resulting in lowered income
and the respective taxes (Comport, 2018). But as the ownership of the asset is not transferred, the
lessee is not eligible to claim depreciation as an expense. The lessor shall claim depreciation as
an expense in his books of accounts. At the expiry of the lease, the lessee also has the option of
either purchasing the asset or renewal of the lease (Porter & Norton, 2014). The operating lease
is usually long term and mainly less than the expected life of the leased asset. 
Where the assets are very expensive, the lessee usually hires the asset on the lease so that the
asset shall be treated as an off-balance sheet item, for example- airlines.
Main Issues with FAS 13 that led to its modification 
The main problem with the FAS 13 was the existence of an operating lease where the lease
reporting was done as an off-balance sheet item. The operating leases involved disclosing only
the lease expense part in the Income Statement of the respective company. The liability of the
leased asset was not shown in the Balance sheet anywhere. The details of the lease transaction
were shown outside the financial statements in the notes to accounts. Due to this reason, the debt
used to get hidden and when the users of financial statements studied only the financial
statements, the debt figures lacked transparency. In the wake of this, there appeared to be many
problem in terms of recognition of debt. Only in the capital lease, the leased asset was to be

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shown on the asset side and the liability of lease on the liability side of the balance sheet of the
company (Peirson et. al, 2014). Various representations were made by many countries for the
elimination of operating leases due to these reporting loopholes. In the year 2001, the Enron
scandal occurred where the heavy investigation had to be done by the SEC due to the operating
lease loopholes. Not only Enron, but there were also plenty of other such cases that prompted the
SEC to rethink about the Lease Accounting Standard. Thus, there was a need to make prompt
modifications in the present Accounting Standard FAS 13.
 
ABOUT THE NEW STANDARD ASC 842
Issues that may arise in the new accounting standard.

 After a lot of representations were made, the FASB had to issue a new accounting standard of a
lease for those companies who were reporting as per US GAAP. Also for the companies which
were reported as per the International Financing Reporting Standards, the board has issued IFRS-
16. These new standards were published in the year 2016 and later an update was also issued in
2018. However, the new lease standard is to be brought into effect by the public companies post-
December 15, 2018 (Effective date of the new standard). However, it may be implemented
mandatorily in January 2019. 
Probably, the new standard shall make the financial statements more transparent concerning the
lease transactions as the reporting of lease asset and the respective liability will be done in the
balance sheet itself. The treatment shall be almost the same as of the capital lease in the old
standard (Lease accelerator, 2018). Although there will be more clarity and transparency in the
financial statements of the companies due to the introduction of the new standard, the companies
will have to face a lot of challenges in implementing the same. This will help in terms of
projecting the correct information and will enable to draw a clear picture. However, it is not free
from the clutches of challenges. The challenges include the following:
 The companies now will have to be very particular about known violations of the
standard and hence have to do the full working of the same along with the lenders. This
means the compliance needs to be complete and since, it is new proper care needs to be
undertaken.

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 The companies have to manage a lot of complexities about the collection, maintenance,
and storage of data. This will lead to consumption of time and resources needs to be
available with the company for the proper code of conduct.
 The internal controls related to the lease transactions will have to be redefined by the
companies. This will further require alterations and other important assessment.
 The income tax implications will have to be well studied and well implemented.
 The application of judgment and estimates will be a challenging task for management
owing to the modified version.
 Educating the investors about the various parameters to be checked while studying the
financial data of the companies such as debt ratio, etc.
 Calculating the valuation of assets and liabilities with full accuracy will be required.
Also, the companies will have to see that there should be transparency in the accounts
about the lease transactions so that there are no violations in the accounting standards
disclosures and reporting (Muna, 2014). The companies need to document every lease
transaction, the asset bills, record of payments, etc.
Many other issues may also be faced by the entities which will apply the new standard. Shifting
from an old standard to a completely new one is not an easy task for such big entities as various
accounting changes are required for the same. Hence it cannot be said with full precision that the
new standard is an issue free standard (Morecroft, 2015). 
Treatment of Leases in the new standard  
The treatment of the new lease standard is quite similar to the one used in the treatment of capital
lease in the old lease standard. Following points shall summarise the current treatment in the
books of the lessee:
 The leased asset shall be included in the fixed assets of the lessee company as normally is
done for the other non leased assets.
 The lease liability shall be shown on the liability side of the balance sheet of the lessee
company.
 The depreciation shall be claimed by the lessee on the leased asset like other asset
depreciation and shall also be claimed as an expense in the income statement. 
 If the lease period is 12 months or more, then only the lease assets and lease liabilities
shall be recognized by the lessees in their books. Otherwise, the lease expenses shall be

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shown in the income statement as an expense as per the straight-line method (Lease
accelerator, 2018).
Expected Economic consequences of the new standard
There may be various economic consequences of implementing the new standard, both positive
and negative. Following are a few examples of economic consequences:
 There may be changes in the computation of tax differences or book differences and there
will direct or indirect impacts of the same on the state tax, central tax or the local tax,
transfer pricing, etc.
 Further, there shall be an increase in the debts of the companies thereby increasing the
income of the lessors, thereby enhancing the economic condition.
 Various important financial ratios may step down like asset turnover ratio and debt-equity
ratio, return on assets, etc.

The manner in which the company classifies capital against the operating expenses will change
by the presence of FASB 13. However, certain conditions need to be duly fulfilled and will help
in the listing of the new assets as capital that was previously needed to be tagged under operating
expenses as per the old model (Melville. 2013). For example, if the lease term extends more than
75% of the economic life of the asset then it needs to be treated as capital. Few other
requirements such as whether the PV of the payments exceeds more than 90% of the value of the
asset will happen at the end of the engagement period (Morecroft, 2015).
Hence, FASB 13 will bring imminent changes in the process of lease accounting. However, the
approach of the company together with the implementation and reporting needs to be properly
ascertained that will help in bringing favorable results. The changes in the lease accounting rules
will have a major influence on the companies and this will influence the return on assets and
various other ratios.

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References

Accounting for leases. (2018). Statement of Financial Accounting Standards No. 13. Retrieved
from: https://www.fasb.org/jsp/FASB/Document_C/DocumentPage?
cid=1218220124481&acceptedDisclaimer=true

Carlon, S. (2019). Financial accounting: reporting, analysis and decision making. 6th ed. Milton,
QLD John Wiley and Sons Australia, Ltd

Comport. (2018). FASB 13: Accounting changes set to affect tech purchases. Retrieved from:
https://comport.com/resources-article/fasb-13-tech/
Laux, B. (2014). Discussion of The role of revenue recognition in performance reporting.
Accounting and Business Research. 44(4), 380-382 Retrieved from:
<https://doi.org/10.1080/00014788.2014.897867>

Lease accelerator. (2018). History of Lease Accounting- Why were the New standards
introduced. Retrieved from: https://explore.leaseaccelerator.com/history-lease-
accounting/

Melville, A. (2013). International Financial Reporting – A Practical Guide, Pearson,

https://www.academia.edu/35299477/International_Financial_Reporting_A_Practical_Gu
ide_Fourth_edition

Morecroft, JD. (2015).  Strategic modelling and business dynamics: A feedback systems
approach, John Wiley & Sons, Hoboken,

Muna, Ed. (2014). FASB 13: How New Accounting Standards Could Impact Your Business.
Retrieved from: https://hughesmarino.com/san-diego/blog/2014/04/16/fasb-13-how-new-
accounting-standards-could-impact-your-business/
Peirson, G, Brown, R., Easton, S, Howard, P. and Pinder, S. (2015). Business Finance, 12th ed.
North Ryde: McGraw-Hill Australia.
Porter, G. and Norton, C. (2014). Financial Accounting: The Impact on Decision Maker. Texas:
Cengage Learning

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