Any business that leases anything for an extended period of time — generally, more than one year — will be impacted by a proposed new accounting standard.
“This may appear arcane to some, but the new rules will have a major impact on the reported financial position of many companies. It has been estimated that this may add hundreds of billions of dollars to the existing liabilities on businesses’ balance sheets nationwide,” says Gerald Weinstein, Ph.D., CPA, a professor and chair of the Department of Accountancy at the John Carroll University John and Mary Jo Boler School of Business.
“Therefore, it is likely that your firm’s financial statements will be affected. At a minimum, expect to see changes in the ways in which leases are being conceived of for recognition and measurement purposes,” says Weinstein.
Smart Business spoke with Weinstein about what the proposed accounting standard would do and how businesses can prepare for the change.
What do you need to know?
Under existing Generally Accepted Accounting Principles (GAAP), leases that are in essence purchases of all of the inherent value of a leased asset are capitalized. Capitalization requires both that the leased asset and related liability for future lease payments be recorded onto the balance sheet. GAAP dictates use of four indicators, any one of which is considered evidence of a so-called capital lease.
Leases that do not meet at least one of the four criteria are operating leases, and are not capitalized. Operating leases are accounted for by expensing the lease payments as they accrue. An example is leasing an office inside an office building owned by another entity.
An operating lease is generally favored by businesses, as it makes the accounting simple in that it avoids recording the liability and depreciating the underlying asset. Further, not booking a liability can improve a company’s debt related ratios. Users, however, would prefer to know about all liabilities the entity has and hence want these liabilities booked. These cross-purposes are being resolved in the proposed standard by essentially requiring all leases to be capitalized.
What will the new standard change?
What defines a lease as a capital lease is changing under an exposure draft (ED) issued jointly by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) on May 16, 2013, and the four indicators noted above will no longer apply. Everyone will be affected if this becomes a final standard in 2014.
All leases, with one exception, would be recognized with a lease liability for the present value of the payments, which must be made over the lease term. As lease payments are made, the effective interest method is to be used to accrete the liability. An asset would be reported and written off to expense over time.
The ED defines the manner of write-off. It depends on the type of asset of which two are defined. A Type A asset is personal property whereas Type B is generally real property. Type A assets are amortized on a straight-line basis unless another method better represents the pattern of use. For Type B leases, the amortization would be the difference between the annual straight-line expense and the interest incurred on the liability.
The most notable change in terms of the direct financial impact is that what has previously been accounted for as an operating lease will now be treated as if it were an owned asset, even if title to the asset will never transfer to the lessee. An office suite leased inside an office building would be accounted for as a balance sheet asset and subject to annual amortization.
What is the exception?
Lessees can elect a policy wherein leases with a maximum possible lease term including options to renew of 12 months or less, are accounted for using a method like that currently available for an operating lease.
How is a leased office akin to an asset purchase?
Leases are being redefined as a contract that conveys the right to use an asset for a period of time in exchange for consideration. The contract must depend on the use of an identified asset and convey the right to control its use. The use of the asset can be either explicit or implicit, such as the lease of a floor of a building. ‘Right to control use’ is slightly different from existing GAAP, which calls it the ‘right to use’ an asset.
Why should you care about recording such a lease as an asset?
Companies should be concerned because booking the asset also means booking the liability. For most businesses, this will have a negative impact on solvency ratios, including debt to assets and debt to equity. This change in the standards could cause your bank loans that have covenants requiring certain solvency ratios to go into technical default.
What can you do to be ready?
Companies should determine which leases they have that will now need to be capitalized, prepare pro forma financials, and determine the impact your solvency ratios. If the new accounting rules cause your debt ratios to deteriorate, consider contacting your lending institution to see if you can re-negotiate the covenants.
While the final standard may undergo some tweaking, changes to lease accounting have been in the works since 2005 and professional accountants expect the standard to be finalized in its current form. The comment deadline on the ED is Sept. 13, 2013.
Gerald Weinstein, Ph.D., CPA, is a professor and chair of the Department of Accountancy at the John Carroll University John and Mary Jo Boler School of Business. Reach him at (216) 397-4609 or Weinstein@jcu.edu.
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