If your business leases equipment, vehicles, office space or other facilities, the proposed lease accounting standards could have a significant impact on your company’s financial statements.
Over the past two years, the business and financial communities have been awaiting finalization of the proposed lease standards that will transform balance sheets. The proposed changes, originally outlined in an exposure draft issued by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) in August 2010, have been delayed due to the large number of comments and questions received during the comment period. Some companies may have been hoping that the scope of standards would be lessened before they were finalized.
However, that doesn’t appear to be happening. In July 2011, the boards agreed to re-expose the revised standards to businesses and financial statement users. While the revised exposure draft isn’t expected until later in 2012, the boards have released some tentative decisions reached in their June 2012 meetings that shed light on how the standards may ultimately look.
“The boards haven’t changed their initial position that long-term leases represent an obligation that should be reported on a business’s balance sheet,” says Mark Lund, assurance services partner for Weaver. “The tentative decisions reached in their last meetings helped clarify some questions raised during the first round of responses from the public. Additionally, the boards appear to have addressed the issue of the acceleration of expenses for lessees in certain circumstances, which was criticized in the initial draft. Beyond that, I don’t see any reduction in scope or administrative relief in the updates.”
Smart Business spoke with Lund about the tentative decisions on the proposed standards and what they mean for businesses.
What are the major components of the proposed lease standards?
The proposed lease standards are a joint effort to help create convergence between U.S. and international accounting standards for leases and to address perceived weaknesses regarding current financial statement presentations of leasing arrangements. Under existing U.S. standards, leases are either classified as capital leases or operating leases. Businesses are not required to include operating lease commitments as liabilities on their balance sheets.
Under the proposed standards, lease commitments — existing and new — are to be recorded on a company’s balance sheet as liabilities with an offsetting asset called a ‘right-of-use asset.’ The lease obligation will be divided between current liability and non-current liability, similar to a note payable, and the existing capital lease presentation. The boards expect to issue a revised draft in the third quarter of 2012 and then take additional comments. The final standard likely will be issued in 2013.
How has the acceleration of expenses over the lease term been tentatively addressed?
In the first draft, capitalization of leased assets and liabilities accelerated the recognition of expenses earlier in the lease term. Companies were required to amortize the asset over the lease term, while the lease obligation was amortized using the effective interest method. That method results in more interest expense being recognized earlier in the lease term. Based on concerns, the boards have tentatively decided leases of property, such as buildings and real estate, can be accounted for using a straight-line approach, meaning the expense recognition will be recorded evenly over the lease term.
However, if your lease term represents the major part of the asset’s economic life, or if the lease payment obligation amount is the equivalent of essentially buying the asset, you won’t be able to utilize the straight-line expense approach. All other leases of assets other than property will continue to be accounted for as outlined in the original exposure draft, including:
- A business will initially recognize a right-of-use asset and the related liability for its lease obligation measured at the present value of the lease payments.
- The right-of-use asset will be amortized, similar to depreciation, on a systematic basis that represents the use or consumption of the asset.
- The amortization expense of the asset and the interest expense related to the liability are shown separately on the income statement.
What are some other key provisions?
The FASB further identified leases that are within the scope of the new standard to include long-term leases of land. Leases of 12 months or less, including the option periods, however, are excluded from the new standard. Proposed financial statement disclosures are lengthy and will add time to comply.
How will the changes impact businesses?
There will be an immediate gross-up of the balance sheet, adding right-to-use assets and related current and noncurrent liabilities to financial statements. The amounts could be significant, depending on lease activity. Bankers, sureties and other users often analyze companies’ liquidity and performance using financial ratios.
Current ratio, debt-to-equity ratio, and other leverage and coverage ratios will be affected with the addition of these new lease liabilities and related interest expenses. Covenant agreements will have to be revised for companies to remain in compliance.
How can employers prepare for the changes?
Prepare a pro-forma of your company’s balance sheet and income statement reflecting the new standard. Then, sit down with the users of your financial statement and discuss how the new standards will impact your company’s financial statements and ratios. This proactive approach will help bankers and creditors plan ahead on what to expect and how to maintain covenant compliance once the standards are finalized.
Mark Lund is an assurance services partner for Weaver. Reach him at (713) 297-6907 or [email protected]
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