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Lease Accounting: Change is on the Horizon
As the old cliché goes, sometimes the only constant in life is change. At least that’s how life has been in the accounting world for the better part of the past decade, and it appears that trend will continue into the future. Much of the recent change is a product of the efforts to converge U.S. GAAP (generally accepted accounting principles) with IFRS (International Financial Reporting Standards). IFRS are the international counterpart to U.S. GAAP and are used in more than 100 countries around the world. The Securities and Exchange Commission (SEC) is currently evaluating whether to require U.S. public companies to begin using IFRS, and the convergence process is an essential element of its consideration.
As part of the convergence process, the accounting standard setters intend to issue new guidance that will affect some of the most complex and contentious areas of accounting, none more so than the accounting for leases. The current lease accounting guidance was written nearly 35 years ago, and although it’s been tweaked over the years to accommodate the evolution of business practices, its core concepts have remained the same. The revised approach currently being contemplated, however, will turn the lease accounting principles on their heads. This will mean big changes for all entities that lease assets.
Lease Accounting as We Know It Today
Leasing has been and continues to be one of the most common forms of financing for real estate, equipment, and other assets. There are many advantages to leasing, including the ability for lessees to only commit to using an asset for a limited period of time along with the reduced cash outlays at the inception of a lease when compared with asset purchases. The accounting rules governing leases have also led to their popularity with some entities. Under current U.S. GAAP, leases are classified as capital leases or operating leases depending upon the terms of the arrangement. Capital leases are accounted for similarly to purchased assets; that is, the company records an asset (for example, a building) and an offsetting liability. Operating leases, on the other hand, are referred to as “off-balance sheet” contracts; this is because no assets and liabilities are initially recognized, and the rent payments are simply expensed when paid in future periods.
It is this off-balance sheet advantage of operating leases that’s helped further the popularity of leases as a form of financing. By keeping lease liabilities off of its books, a company’s balance sheet looks healthier. At the same time, this off-balance sheet treatment has attracted the attention of regulators and accounting standard setters, many of whom believe that all lease contracts should result in assets and liabilities being recorded by lessees.
Lease Accounting as It May Look in the Future
The accounting standard setters, the Financial Accounting Standards Board (FASB) for U.S. GAAP and the International Accounting Standards Board (IASB) for IFRS, have issued a joint proposal detailing how they think leases should be accounted for in the future. The proposed model represents a radical change from the past and would require assets and liabilities to be recognized for all leasing arrangements. In essence, the proposal will eliminate the off-balance sheet accounting currently used for operating leases. The new standard would also change how lessors account for leases.
For companies that rely heavily on leases for financing purposes, the new accounting guidance could create significant changes to their financial statements. This is especially true for those companies with leases currently accounted for as operating leases (off-balance sheet). The new lease guidance would make obvious changes to the balance sheet through the reporting of lease assets and liabilities. This will generally result in higher debt-to-equity ratios, and companies will look more “leveraged” than under the current guidance.
The new standard could also have a significant impact on earnings. Operating leases today result in rent charges that are recognized in operating expenses; however, these will be replaced with amortization and interest expense as the lease assets and liabilities are reduced over time. For companies that measure their financial performance using metrics such as EBITDA (earnings before interest, taxes, depreciation and amortization), the results under the new guidance would be different. In addition, the timing of when the expenses are recognized in the income statement will also change, with expenses generally recognized sooner under the proposed guidance.
What Should Companies Be Doing Now?
The proposed guidance is expected to be issued in June 2011. While no decision has been made on an effective date, it’s not expected that companies will need to begin using the new standard until 2013 or 2014. However, given the potential impact of the proposed changes to lease accounting, companies involved in lease arrangements should begin to assess the implications now. The proposed guidance does not include a “grand-fathering” provision and, as a result, all existing lease contracts will need to be analyzed and the accounting changed to conform to the new approach.
The following steps can be followed to perform an impact assessment:
Prepare an inventory of existing leases. Be sure to include pools of small-dollar leases, such as vehicle fleets or computer rentals that could collectively be significant.
For significant lease arrangements, review the contracts and agreements to summarize the key provisions, including:
Residual value guarantees and other provisions that could affect whether renewal options are exercised.
Calculate the estimated impact for significant leases.
Prepare a pro-forma balance sheet and income statement assuming the proposed guidance was effective.
Companies should also evaluate strategic plans to identify situations where lease vs. buy evaluations could be affected by the proposed accounting change.
A change to the lease accounting guidance could also have significant hidden impacts. For example, many compensation, loan, and sales and purchase agreements have provisions based on earnings or other financial metrics that could be affected by the proposed guidance. It’s important to identify those arrangements now so that there’s time to renegotiate the terms before the impact is felt in the financial statements.
Change is on the horizon for lease accounting. And while the changes aren’t expected to be seen in financial statements for at least a couple of years, now is the time to begin preparations. Companies that have performed an impact assessment and are ready in advance of the change will meet the goal of every business executive, investor, and lender – no surprises.