Lease Accounting Rules Are About to Change… Get Ready!

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To help minimize the pain U.S. companies will endure when the U.S. moves to the Internal Financial Report Standards (IFRS) in the future, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are working on several new standards to revise existing U.S. Generally Accepted Accounting Principles (GAAP).  Lease accounting is one of four remaining major areas in which FASB and the IASB are trying to reach convergence in standards.  The proposed lease accounting rule changes could arguably be one of the largest the accounting professional has seen, not only in the U.S. but worldwide.

The rationale for the changes is that existing lease accounting is not consistent with the underlying economics of business transactions.  For example, does it make sense that an airline’s balance sheet doesn’t show airplanes?  Sir David Tweedie, Chair of the IASB Board, thinks not.  He was quoted as saying, “One of my main goals in life is to one day fly on an airplane that actually appears on the balance sheet of an airline.”

The fundamental proposal being put forth is that lessees will need to record all leases on their balance sheet, similar to how lease accounting is currently done for capital leases.  A liability will be recorded for lease obligations, and an asset will be recorded for a right-to-use asset, which will be amortized.  This change could be monumental in the accounting profession because it will necessitate the following practice changes:

A liability will be recorded for lease obligations at the ‘present value of the lease payments’ (payments) and interest expense will be recorded using the effective interest method.

  • The payments should use a discount rate equal to the lessee’s incremental borrowing rate and need to include:  estimated contingent rents and renewal options based on a “best estimate” approach, amounts payable under residual value guarantees, expected payments for nonrenewal option penalties and the exercise price of a purchase option if the lessee has significant economic incentive to exercise the option.
  • At each reporting period subsequent to recognition of a lease, companies will have to reassess the estimates used in the calculation of the payments, such as contingent rents.  If there are any differences between actual and estimated payments, after reassessing the estimates, than the differences are run through the income statement if such differences are considered to be related to the current period.  If the differences are considered to be related to future periods, then the differences will be reflected by adjusting the balance sheet.  A right-to-use asset will also be recorded at an amount equal to the obligation liability plus initial direct expenses minus any lease incentives and will be amortized over the shorter of the lease term or the asset’s estimated useful life.
  • The appropriate lease term to use will be the longest possible term that is more-likely-than not to occur and consideration must be given to all relevant factors such as history, existence of renewal options and renewal rates, termination penalties, the importance of the underlying lease’s asset to lessee operations and the significance of leasehold improvements.  Certain shortcuts will be allowed for short-term leases.  A short-term lease is a lease where the maximum possible term, including renewal options, is twelve month or less.  Lessees with short-term leases may elect to treat their leases as operating leases.

Most companies are concerned about the transition to these new accounting practices, and rightfully so.  There will be no “grandfathering” during the transition and all existing leases will be recognized using a retrospective approach whereby the opening equity balances will be adjusted for the prior period as if the new accounting policies have been applied from the beginning of the earliest period presented.  For existing operating leases, upon transition, the liability will be recorded equal to the present value of the remaining lease payments and the discount rate will be equal to the incremental borrowing rate on the date of application.  The right-to-use asset will be adjusted for any prepaid or accrued lease payments.

As a result of these changes, the fiscal picture of companies with significant leases will also change drastically.  Foreseen impacts include:

  • Balance sheets will swell, causing financial profiles to change, possibly dramatically, and the adjustments for changes in estimates will result in increased balance sheet volatility.  Despite the fact that the tax treatment for leases remains the same, the changes will give rise to additional book-to-tax differences.
  • Banks and other regulated entities that have their financial performance indicators watched with a keen eye, such as a bank’s capital ratios, will be particularly impacted by the new accounting rules due to the grossing-up of the balance sheet and resulting decrease in capital ratios.
  • The changes could potentially have significant impact on a company’s debt covenant compliance; earnings before interest, taxes, depreciation and amortization (EBITDA) will increase since rent expense will be re-characterized as interest and amortization expense yet certain financial statement ratios, such as net worth-type ratios, will worsen.

There will be significant changes to lessor accounting rules as well; however, this article focuses on lease accounting for lessees.

To prepare for the changes which will likely go into effect in the years ahead,* companies should start inventorying and analyzing their existing leases now so their adoption of the new accounting rules goes smoothly.  Consideration should be given to creating a lease database which catalogs all existing leases and the pertinent information and assumptions that will be needed to calculate the lease obligation such as lease term, renewal options, and payments.  Depending on the number of leases and the availability of lease information, this could be a very time consuming effort.  Not only will the creation of a database take a considerable amount of time, the ongoing maintenance will as well and therefore companies will also need to consider the impact of this on their resources and processes.

If you would like to discuss further, please contact your BNN advisor at 800.244.7444

Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.

** The original Exposure Draft (ED) was issued in August 2010 with an original target date of June 2011. Because of the significance of the proposed changes, the FASB received hundreds of comments letters and has undergone significant outreach relating to its ED. Many comment letters relate to disagreements with the ED’s definition of lease term in that the accounting for leases will require the recognizing of amounts that don’t meet the definition of a liability and that it is highly subjective, giving rise to manipulation. The FASB and IASB have deferred issuance of the ED several times as the topic has been debated at nearly every meeting since the original ED was issued. The revised ED is expected to be issued sometime in late 2012 with an effective date not likely before 2015.