Client Advisor - Proposed Changes to Lease Accounting
What Do the Newly Proposed Lease Accounting Rules Mean for Your Company?
Dec. 14, 2010
The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) are working together on a number of projects that will improve existing accounting standards and help keep convergence between U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) moving forward. Accounting for leases is one of the more significant of these projects, the outcome of which could have a significant impact on your company.
Proposed Accounting Changes on Lessees
In an Exposure Draft recently issued by the FASB and IASB resulting from their joint leases project, substantial revisions to accounting for leases have been proposed that will change how lessees and lessors account for and report leasing arrangements on their financial statements.
The Exposure Draft proposes a single model that will be applied to substantially all leases that would effectively end off-balance sheet reporting of what are, today, referred to as “operating leases” by lessees, eliminating the distinction between operating and capital leases.
As currently proposed, the guidance will affect not only new leases entered into after the adoption date, but also existing leases as no leases would be grandfathered. The proposed accounting model also will require entities to make a number of estimates at the inception of the lease and periodically reassess those estimates.
This will have no bearing on how leases are treated for income tax purposes; however, the difference between book treatment and tax treatment may create some deferred income tax issues.
Background and Criticisms of Existing Accounting for Leases
The proposed changes are designed address some of the more frequent criticisms of the current lease accounting model including:
- Lease transactions with economically similar characteristics can result in different accounting treatment due to bright line quantitative criteria
- Material assets and obligations arising from operating leases are not recorded on the balance sheet
- Estimates at the inception of a lease are not required to be periodically reassessed
Proposed Accounting for Leases by Lessees
The key provisions of the proposed lease accounting standards are as follows:
- A lease is defined as a contract in which the right to use an asset is conveyed, for a period of time, in exchange for consideration.
- Lessees would record an asset representing the right to use the leased item for the lease term (“right-of-use asset”) with an offsetting obligation to make lease payments.
- Right-of-use assets would be included within property, plant and equipment but classified separately from owned assets on the balance sheet. Leased asset(s) would be subject to evaluation for impairment at least annually.
- Right-of-use assets would be amortized over the shorter of the useful life or lease term.
- Lease obligation recorded at inception would be at the present value of the obligation to make future payments computed based on an estimate of the lease term. The lease obligation would be presented separately from other liabilities on the balance sheet.
- The lease term would take into consideration renewal options that are “more likely than not” to be exercised. This is a significant departure from current GAAP which requires a much higher threshold of “reasonably assured” for inclusion in the lease term.
- The lease payments used to measure the initial value of the asset and liability would include an estimate of contingent rentals and residual value guarantees, another notable change from current GAAP.
- The interest rate used to compute the present value of the lease obligation would be based on the rate the lessor charges the lessee if it can be readily determined, otherwise the lessee’s incremental borrowing rate would be used.
- Lessees would be required to periodically reassess the estimates and judgments due to changes in facts and circumstances. Changes that relate to current and prior periods are adjusted through the current income statement while changes to future periods are adjusted through the leased asset and associated lease obligation. Current GAAP generally does not permit re-assessment.
- Lease payments would be allocated between a reduction to the lease obligation and interest expense. Interest would be computed using the effective interest method.
The exercise price of any purchase option included in a lease agreement would not be a lease payment and the purchase option is not included in determining the present value of lease payments obligation.
As proposed, leases with an automatic transfer of title or bargain purchase option normally would be considered in-substance purchases and excluded from the scope of the proposed new leases standard; therefore, some capital leases under current GAAP may not be in scope.
Although it is not clear how such arrangements will be accounted for or what the transition provisions (if any) will be for such arrangements, they are expected to be accounted for as a financed purchase of an asset to more closely match the economic realities of that transaction.
A journal entry would need to be recorded for a cumulative effect of a change in accounting with the offset to equity as of the date of initial application to the extent that the amounts recognized under the new standard differ from the amounts previously recognized under existing GAAP.
Additional Disclosures
The proposed standard would require a significant increase in volume of disclosures in comparison to current guidance. Certain requirements, including disclosing significant judgments and estimates and balance sheet roll-forward information, will necessitate that information on leases not previously needed for disclosure purposes be tracked and compiled.
When Will the Standard be Effective?
Comments on the Exposure Draft are due to the Boards by December 15, 2010. The Boards currently plan to issue the final standard on leases in 2011, subject to the extent of comments they receive and whether they feel a need to re-expose this with any substantive changes. At present, the standard is expected to be effective in 2012 at the earliest, however retrospective adoption has been proposed as discussed further below.
Upon Adoption to What Periods Would the New Standard Apply?
As proposed, the standard would be adopted using a simplified retrospective approach whereby the new lease standard would be applied on the first day of the earliest period presented. In other words, if the standard is adopted in 2012 and comparative financial statements are presented, then the new lease standard would apply to the years 2011 and 2012 with retrospective application back to January 1, 2011.
Evaluation of Potential Impacts to Your Company
Although the effective date may still be a couple years away, companies should consider evaluating the resulting impact of the proposed standard on their financial statements, debt agreements and information management.
Potential Impact on Financial Statements
A likely impact on the balance sheet is a growth in assets and liabilities which would result from increases in right-of-use assets and related lease obligations recorded.
The impact on a company’s income statement is that rent expense previously recorded for operating leases would be replaced by interest expense and right-to-use asset amortization. Interest expense would be greater in the earlier years and lesser in later years similar to a mortgage. The result would be lower earnings early in lease terms and higher earnings later in lease terms compared to straight line recognition of rent expense under current accounting guidance. Changes in the timing of expense recognition, if material, could also have an impact on compensation arrangements.
Potential Impact on Debt Covenants and Financial Ratios
An increase in capitalized right-to-use-assets would result in higher debt recorded on a company’s financial statements which may cause it to exceed maximum borrowing limitations and would lower working capital.
The increase in debt may also have a negative impact on key financial ratios including a company’s debt to equity ratio, interest coverage ratio and fixed charge/debt coverage ratio even though cash flows and business activity will not have changed.
On a positive note, a company’s Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA) would increase as a result of a decrease in rent expense and an increase in both interest and amortization expense.
Since these changes will affect all borrowers, your company will not be alone in having to deal with the implications of these changes to debt covenants. We would expect the banks to be addressing amendments to loan agreements, and we will be working proactively with our clients to ensure their issues and concerns do not get overlooked.
Potential Impact on Information Technology and Systems
As the current accounting requirement for leases are relatively basic, companies are able to utilize less sophisticated methods/systems such as Excel spreadsheets to track leases and associated rent expense. However, as the new standard would likely require more assets and liabilities be recorded on the balance sheet, this would require periodic re-evaluation and require different income statement treatment. As a result, companies may need a more refined accounting process/system to capture, track and manage the critical contractual information and compute the periodic accounting activity.
What Should Companies Do Now to Prepare?
In preparation for adoption of the proposed lease accounting standard, we recommend that companies consider performing the following:
- Watch the news and alerts that we will send out for further developments on this proposed standard so that you are up to speed with progress on this.
- Aggregate all lease agreements (whether capital or operating under the current standards) in one place to obtain an understanding of the volume of lease agreements outstanding in order to assess the magnitude of effort required for the adoption of the standard.
- Prepare a formal inventory of all existing leases that summarizes the key terms including payment amounts, lease term, renewal options and contingent payments.
- Compute an estimate of the company’s right-to-use assets and related lease obligations as of a specified future date (such as January 1, 2012) to quantify the potential impact of the proposed standard on the company’s financial statements and ratios.
- Consider the impact of the proposed accounting standard on debt covenants and regulatory requirements, if applicable, and begin dialogue with lender(s) and regulator(s) as deemed appropriate.
- Consider the potential impact of the new standard when entering into new lease agreements including the lease term, renewal and bargain purchase options and contingent payments.
- Educate members of senior management, board of directors and key investor stakeholders on the potential impact of the standard on the Company’s future financial results and reporting.