Operating and Capital Leases under GAAP and IFRS

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The IASB and the FASB proposed a new accounting model that will enhance transparency and reduce complexity in the current accounting standards on lease contracts. In a Board meeting contacted in March 2009, members proposed significant changes to be made on how leases on assets and liabilities are to be accounted for in financial statements. These principles formed a basis for lease evaluations of the IAS 17, practices, and standards as explained in the joint discussion paper of the boards and their subsequent recommendations. The accounting standards mentioned in this article distinguish different frameworks used in classifying finance leases and operating leases and summarize the key provisions of the project that led to the Accounting Standards Update (ASU). The proposal also highlights specific areas of FASB Codification to be amended and explains the basis of the Board’s decisions.

The objective of lease Accounting

The objective of the lease accounting joint project was to prescribe new accounting standards to be used for lessees and lessors and provide appropriate accounting standards and disclosure to be applied about lease agreements. In general terms, the new proposal will improve the functioning and effectiveness of accounting standards on lease agreements that will allow the lessor and the lessee to transfer the right of use of assets. Also, the new accounting standards will ensure that all substantial services regarding assets and liabilities are accounted for in the financial statements. Together with a selection of its observation and recommendations, the board argues that the new accounting policies on leases should be based entirely on the principle that all leases give rise to liabilities. In this case, leases are to be considered as expenses due to their uncertainty. For example, liabilities incurred due to renewal options or obligations to pay rentals should be considered as liabilities (Ernest & Young (a) 5).

Key proposals on lease Accounting

The Board’s project on leasing is expected to provide a new face on how leases accounts are to be classified depending on the lease term which falls under new categories; operating leases and capital leases. The board recognizes that this new accounting policy will enable leases to be recorded as assets and lessees will represent their right to use the leased asset during the lease period and will incur liabilities for their obligation to make rental payments under the lease.

The key proposals made by this joint project deal primarily with how lessee accounting might change the current accounting standards. The new model proposes that the right of use of an asset be financed over the lease term or the economic life of the leased asset and they seek to eliminate operating leases for lessees. For example, a lessee that leases one floor of an office building under a five-year lease with no renewal option would record this on a balance sheet as an asset for the right to use the space for the term of the lease and a liability for the obligation to pay rentals (Ernest & Young (a) 6:Horowitz online).

The current status of the board is tentatively decided to defer the development of a new accounting model for leases and to concentrate on developing a new accounting model for leases. In a comment letter addressing conceptual framework on general issues arising from the Exposure Draft and the Discussion Paper (Agenda paper 2C) IASB comments on the draft stating that all comments were treated with equal weight and most respondents supported the project recognizing its important role in the high-quality financial report. A few respondents however questioned whether the existing frameworks are a good starting point for the revised and converged framework. Many correspondents however welcomed the proposals that respondents should assume that the framework’s authoritative status will be elevated in the US GAAP hierarchy comparable to IFRS (Ernest & Young (a) 7; Horowitz online).

Comparison of GAAP Codification and LAS 17

The proposed International Accounting Standards (IAS) 17 focuses primarily on leases agreements of assets and liabilities. Although the Board’s proposal gives more detailed information on the current US GAAP and IFRS accounting standards regarding lease contracts, it’s important to note that these issues are relevant to all policymakers and financial reporters, and these significant changes will improve the functioning and effectiveness of financial statements. The contrast in the lease accounting standards can only be classified into two categories, capital, and operating lease. In its pursuit of these goals, the Board discussed the critical areas that financial reporting should adhere to, and below is a summary of key principles identified in lease agreements that I will be dealing with briefly in this paper.

  1. Lease transfer ownership of properties
  2. Bargain purchase option of a lease
  3. The present value of a lease at the beginning of the lease term (Mc Gladrey & Pullen online)

IAS 17 classifies lease agreements as finance leases upon the transfer of all risk and rewards at the time of ownership which is assessed through a series of indicators similar to those applied to U.S. GAAP although this particular one does not enlist a numeric threshold. For example, if an estimated economic life of an asset is presumed to be 77 percent, the indicators are not always conclusive and assets may be classified individually. Therefore this particular asset may not automatically qualify to be classified as a capital lease. The indicators used in GAAP provide a standardized format for lease classifications and ensure that all preparers comply with the set accounting principles. On the other hand, the new GAAP classifies all risks and rewards transferred during the ownership of an asset as a finance lease and gives detailed examples of how such assets qualify for such transfers. In this case, finance leases under the new IAS 17 can only be transferred with the permission of the lesser. The title transfer will only qualify if the lesser chooses to enter into a new lease of an equivalent asset with the same lessor and a lessee can only transfer the leased property upon payment of a reasonable amount at the inception of the lease while the GAAP and IFRS only authorize the transfer ownership at the end of the lease period (Mc Gladrey & Pullen online: IAS 2).

Similarities in both accounting standards are that both parties bear all the risks and rewards gained through ownership of the leased asset and they both use specific indicators in determining when an asset qualifies to be capital or an operating lease. They also both classify leases as either capital or operating leases and separately discuss how accounting standards apply to both the lessee and the lessor. Under AIS 17, indicators used in determining whether a lease is operational or capital lease are not conclusive. For example in a case where a lease does not substantially transfer all the risks and rewards at inception, the contract is termed as an operating lease. A lease becomes operational when the lessor decides to transfer the ownership of the asset for a variable payment equivalent to the fair value or inclusive of contingent rents however this arrangement does not substantially transfer all the risks and rewards. Classification of a lease is made at the inception of a lease, and if both parties decide to change the provisions of the lease that would result in a different classification, then the revised agreement will be considered as a new agreement and reasonable lease transfer treatment will be exercised (IAS 5).

When determining the present value of minimum lease payment, the GAAP uses incremental borrowing rate, and if the determination is not practical, while under IAS 17, the lessor might choose the implicit rate under certain conditions and also requires its capital leases to have a bargain purchase option (Mc Gladrey & Pullen online).

Under GAAP and IFRS, a lessee records capital lease by recognizing and measuring assets and liabilities at lower present values of the minimum lease payments or through measurement of the fair value of the asset. For this case, a lease would calculate the operating lease by recognizing expense on a straight-line basis over the lease period and any incentives incurred will be amortized on a straight-line basis over the lease period (Ernest & Young (b) 34). The LAS 17 also classifies expenses under operating lease and calculates them on a straight-line basis although it offers a flexible systematic basis to choose from depending on the time pattern of the user’s benefit. It further classifies operational lease (lease payments) as insurance and maintenance costs and which should be calculated on a straight-line basis over the lease term depending on the time pattern of the user’s benefit regardless of whether the payments are on that basis or not (IAS 9).


The IAS17 proposed accounting standards are relatively flexible and transparent compared to the IFRS and GAAP requirements which are rather rigid. Overall the joint project should address issues on the convergence of the current scope differences that exist between US GAAP and the IFRS leasing accounting standards.

Works Cited

Ernest & Young (a). “Leases Project Preliminary Views. IFRS Outlook (2009):1-16.

Ernest & Young (b). “US GAAP vs. IFRS”. The basics: Life Sciences 2009 No.BB1776 (2009): 1-48.

IASB Standards. “International Accounting Standard 17”. A Guide through IFRS 2.1 (2009):1-18.

Horowitz, Lynn. FASB Accounting Standards Codification. Web.

McGladrey&Pullen. 2009. Leases: IFRS vs. U.S. GAAP. Web.

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