The FRF provides guidance for lessees’ accounting for capital and operating leases, and for lessors’ accounting for sales-type, direct financing and operating leases. The principles are based on the view that property has benefits and risks related to ownership. Further, the FRF takes the position that when a lease transfers substantially all the ownership benefits and risks it is essentially an acquisition of an asset and the incurrence of an obligation and should be accounted for as a capital lease by the lessee and either a sales-type or direct financing lease by the lessor.
This guidance does not apply to copyrights, patents and other licensing agreements which are account for as intangible assets. Following is a discussion of basic lease accounting principles under the FRF.
One or more criteria in a lease agreement indicating transfers of substantially all the benefits and risks of ownership to lessees, similar to currently applicable U.S. GAAP, includes:
- Transfer of ownership at the end of the lease term or a bargain purchase option (that would cause the lessee to purchase).
- A lease term that will enable the lessee to receive substantially all the economic benefit from the asset. This would normally be a term that is 75% or more of the remaining useful life of the asset. This criteria normally would not apply to land unless there is reasonable assurance ownership will transfer at the end of the lease term.
- The lessor has some assurance of recovering the cost of the assets and earning a return on that investment. This assurance exists if, at the inception of the lease, the present value of the minimum lease payments excluding executory costs is 90% or more of the market value of the asset. The discount rate that should be used to determine present value is the lower of the lessee’s incremental borrowing rate or the interest rate implicit in the lease if it can be obtained or estimated (the implicit rate will be used by a lessor).
For lessors, the benefits and risks of ownership normally are transferred when:
- Any one of the criteria above is met.
- Credit risk is similar to other receivables.
- Non-reimbursable costs likely to be incurred by the lessor can be estimated to determine if substantial risks are retained, thereby preventing capitalization of the lease
A lease of an asset that transfers substantially all the benefits and risks of ownership should be accounted for as a capital lease by the lessee and a sales-type or direct financing lease by the lessor.
My next blog will discuss further lease accounting treatment for lessors.