Proposed lease accounting rules could have a serious impact on businesses that have significant leasing activities.
A draft standard for lease accounting developed by the U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) will affect any business that enters into a long-term lease and result in significant accounting changes for both lessees and lessors.
“There is a lot of controversy over this new draft standard for lease accounting,” says John Helmuth, a director in the Audit & Accounting group at Kreischer Miller, located in Horsham, Pa.
The current accounting guidance has been criticized for not requiring all lease commitments to be recorded on a company’s balance sheet, resulting in inconsistency for banks and other third parties that require a business’s financial statements. Under current standards, companies aren’t required to include operating lease commitments as liabilities on their balance sheet unless they meet certain criteria to be treated as capital leases, and some users of financial statements are seeking a more black-and-white approach.
Smart Business spoke with Helmuth about the proposed lease accounting rule changes, what businesses should know and how they can prepare for the impact that it may have on them.
How did the proposed lease changes come about?
Mainly, there has been feedback from users of financial statements, such as banks, that they are not getting a clear financial picture of a company’s leasing activities. Balance sheets don’t show the complete picture in some cases.
For example, companies are required to include capital leases on their balance sheets, but operating lease commitments are only included as a note disclosure to the financial statements. A company could be committed to paying a lease obligation, but that lease might not have been recorded on the balance sheet. Essentially, certain leasing activities could have been left off of the balance sheet, making the financial statements inconsistent with reality.
In reaction to this, the FASB and IASB created an exposure draft of proposed lease accounting changes. The proposed rules affect lessees and lessors, and there are significant changes for both parties. For now, there is still discussion, and a revised exposure draft is expected to be complete in the next several months.
How could the proposed changes impact businesses that lease space?
The new model would result in the elimination of off-balance-sheet lease financing for lessees. The proposed rules require that lessees record leasing arrangements based on a right-of-use model. Under that model, lessees would recognize an asset representing its right to use an underlying asset during the lease term and a liability representing its obligation to make lease payments during the lease term.
Additionally, there will be no distinction between operating and capital leases, and therefore, no ability for a lessee to leave a lease obligation off of the balance sheet. Depending on a company’s lease portfolio, this requirement could have a serious impact on the balance sheet.
For example, consider corporations that lease large facilities across the country. Under the new proposed guidance, these companies will be required to record assets (right-of-use) and liabilities to make lease payments. Interest expense will be recognized on the liability to make lease payments and the right-of-use asset will be amortized over the shorter of its estimated useful life or the lease term. It will change the income statement from a budgeting standpoint, because rent expense will be essentially replaced with interest and amortization expense.
Essentially, the proposed changes will result in assets and liabilities being ‘grossed up’ because all leasing transactions will be recognized on the balance sheet. This could deteriorate key leverage and capital ratios. Also, the proposed rules will require a system for gathering and tracking lease data, which could be extremely cumbersome.
How will lessors be affected by the proposed rules?
There are proposed changes to accounting by lessors also. The FASB and the IASB introduced the receivable and residual approach.
Under this approach, lessors would derecognize the underlying leased asset and initially measure the right to receive lease payments at the present value of the lease payments, along with a residual asset measured at the lease commencement. This model does not apply to short-term leases or leases of investment property.
How can businesses best prepare for these proposed lease accounting changes?
For now, the proposed lease accounting changes are still under debate. But it is prudent to consider how these rules will impact your business if they are put into effect tomorrow. How will this change your balance sheet? How could the rules impact budgeting?
Businesses of all sizes will see a definite difference in their financial statement presentation, so it’s important to get a handle on the lease commitments you currently have. Quantify those and project the potential financial impact on financial statements. And begin tracking and keeping careful lease records that will help you make business decisions about leases down the road. Now is the time to discuss with your banker any debt facilities that require financial covenants that could be revised based on lease accounting changes.
And businesses should consult with a trusted accounting adviser, who will help them implement any processes. An experienced accountant will guide you through these lease accounting changes and make recommendations to ease the process.
John Helmuth is a director in the Audit & Accounting group at Kreischer Miller, located in Horsham, Pa. Reach him at (215) 441-4600 or email@example.com.
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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 firstname.lastname@example.org.