The switch from Generally Accepted Accounting Principles to International Financial Reporting Standards is a primary concern that has been in focus for most corporations, but there is another accounting practice change in the works that could have a $2 trillion impact on U.S. companies.
“The proposed lease accounting rules will apply to all companies that lease plants, property or equipment and will change the way that leases are accounted for,” says William Sammons, a partner at Nichols, Cauley & Associates, LLC.
“The lease accounting models currently in place have come under much criticism for failing to meet the needs of users of financial statements,” Sammons says. “As a result, the Financial Accounting Standards Board and International Accounting Standards Board have initiated a joint project to develop a new approach to lease accounting to ensure that assets and liabilities arising under leases are appropriately recognized and disclosed.”
Smart Business spoke with Sammons about the impact of the proposed changes and what you can begin doing now to prepare.
Where does the project currently stand?
Two years after the standards were first discussed, the project is in the final rule phase. The new standards are expected to be implemented between January 2013 and 2015. There will be no grandfathering exceptions and, as such, all existing long-term leases must be recorded on the balance sheet prospectively under the new rules in anticipation of implementation.
The original exposure draft outlined only one method of accounting for all leases, raising concerns about whether this single model would be sufficient. So in April of this year, the boards identified two types of leases for lessees and lessors, with different profit and loss effects: a finance lease with a profit-and-loss pattern and an other-than-financing lease with a profit-and-loss pattern consistent with current operating lease accounting under GAAP. However, the boards are still in the process of determining which indicators would distinguish the two. The further review deals with the method to account for the cost of the leases and not with whether they are reflected on the balance sheet.
What are some of the significant changes?
Generally speaking, all long-term leases would appear on the balance sheet and no distinction would be made between operating and finance leases. In addition, assets and liabilities would be grossed up and the lease assets would represent the right to use the leased asset.
Lease liabilities would be re-evaluated at each reporting date when inactions or significant changes exist. The proposed rules may also require significant changes in internal controls and information systems.
Other changes would include the deterioration of capital and leverage ratios; the timing of expense recognition would accelerate and expenses would be recharacterized as interest and amortization expense. EBITDA (earnings before interest, taxes, depreciation and amortization) would be more favorable and, on the cash flow statement, cash flows from operating activities would be more favorable.
Also, significant tax issues may arise with the proposed changes.
How much disclosure will be required?
It is up to the entity to determine the level of detail necessary to satisfy the disclosure requirements. The entity should disclose the nature of its lease arrangements, including the existence and terms of renewal or purchase options, escalation clauses and restrictions imposed by lease arrangements, reconciliation of opening and closing balances for assets and liabilities and minimum sublease rentals to be received in the future under noncancelable subleases, among others.
How will the proposed changes impact businesses and what should they do now to begin preparing?
With the proposed rules for capital leases, the accounting treatments will change, as will the balance sheet presentation and the disclosure requirements. According to a recent survey of company executives, just 7 percent claimed to be extremely or very prepared for the proposed lease accounting standards. The survey also indicates the proposed changes could have a substantial impact on the financial statements of lessees, as it could impact debt to equity ratios and existing debt covenants, make it more difficult to obtain financing, lead toward shorter-term leases and encourage lessees to buy instead.
Lenders often set financial loan covenants based on a company’s financial position, which has an effect on overall terms of the loan, including pricing. Upon adoption of the lease accounting changes, many companies will find they are no longer in compliance with their loan covenants even though there has been no change in their financial position.
To understand how this will affect your business, estimate the effect of capitalizing existing operating leases. If there is a significant potential of covenant violations, you can amend existing loan agreements so loan covenants specifically exclude the effects from lease accounting changes, modify existing amounts used in setting financial loan covenants, or modify definitions of loan covenants to specifically exclude capital leases from covenant calculation.
There are also tax implications to consider, as most leases will now have a deferred tax component. This may impact business income apportionment and sales/property tax considerations. As a result, it would be wise to evaluate lease versus buy considerations.
Companies involved in lease arrangements should start now to evaluate the implications of these new standards. Begin by taking inventory on existing leases. For significant lease arrangements, review the contracts and agreements to summarize key provisions such as lease payments, renewal options, purchase options and residual value guarantees.
Estimate the impact for significant leases, and prepare a pro-forma balance sheet and income statement, assuming the proposed guidance is effective.
William Sammons is a partner at Nichols, Cauley & Associates, LLC. Reach him at (404) 214-1301 or email@example.com.