Lease Accounting Changes Coming Down the Pipeline

Joe Boruff

The proposed change in accounting for leases will apply to all entities, including privately held companies and nonprofit organizations, who prepare their financial statements in accordance with US generally accepted accounting principles (“GAAP”). Entities with a significant amount of leasing activity could see dramatic changes to their balance sheet.

Overview:

Simply put, the goal of a recent exposure draft jointly published by the Financial Accounting Standards Board (“FASB”) and International Accounting Standards Board (“IASB”) is to eliminate operating leases and get virtually all leasing transactions on the balance sheet for all entities. Generally speaking, all leases will have to be capitalized on the balance sheet once this proposed requirement is adopted. It will supersede the guidance in Topic 840 (FASB Accounting Standard Codification) on leases and IAS 17, Leases, in IFRSs (International Financial Reporting Standards).

Under current US GAAP, leases are treated as either capital leases or operating leases. These models have been criticized because they do not provide the user of the financial statements with an accurate representation of leasing transactions as they may not necessarily reflect the underlying economic reality. Current lease accounting allows for off-balance-sheet treatment of leases.

The exposure draft proposes that lessees and lessors should apply a right-of-use model in accounting for all leases. This means that the lessee recognizes an asset representing its right to use the leased property and a liability for the obligation to make future lease payments. The lessor recognizes an asset representing its right to receive lease payments and then must consider one of two approaches: the performance obligation or derecognition approach.

In light of the overall issues discussed in the IFRS convergence and its differences from GAAP, this is one area that will be pervasive for all entities ranging from the smaller privately-held companies to publicly traded companies, whether they are domestic or international.

Summary:

-          All leases for all entities must be reflected in the balance sheets of lessors and lessees.

-          There is no distinction between a “capital” lease and “operating” lease.

-          Smaller companies will be able to treat the change prospectively, upon adoption

-          Larger companies will treat the change retroactively (affecting each year presented in the current year financials), upon adoption

-          Lease terms of 12 months or less would not be capitalized by either the lessee or lessor.

-          Changes will increase debt and may affect loan covenant ratios. Changes will also likely increase EBITDA as leases currently recognized as “operating” will now have “amortization” expense and payments will reduce liability obligations under the new framework.

-          As this will apply to all entities preparing financial statements according to GAAP, some entities may opt to prepare their financial statements in accordance with an Other Comprehensive Basis of Accounting (“OCBOA”), for example, income tax basis, for third party use where OCBOA basis presentation is accepted.

Important Dates:

August 17, 2010 - The initial exposure draft for the proposed accounting standards update was issued.

June 13, 2012 - a joint press release was issued noting all decisions reached to that date were preliminary and a revised joint exposure draft would be issued in the fourth quarter of 2012. The revised exposure draft will address both the balance sheet and income statement treatment of leases to be adopted for lessees and lessors.

The FASB and IASB anticipate completing this important convergence project during 2013.

Let me know how I can be an asset to you and make this convergence one of the lease(t) of your worries!

Please follow this link to the actual FASB/IASB Exposure Draft for further details: