Brushing up on new accounting standards may not be your idea of a good time, but understanding the proposed changes to the lease accounting standard is more than just a good idea; it may be crucial to your financial statements. The Financial Accounting Standards Board and the International Accounting Standards Board reached a preliminary agreement in June 2012 for a new accounting standard that will dramatically change lease accounting rules.
The proposed standard will virtually eliminate operating lease accounting treatment for leases greater than one year in duration. For companies that lease real or personal property as either lessors or lessees — this broad swath includes most companies — the changes will affect how leases are accounted for on the company’s financial statements.
Under current FASB lease accounting rules, lessees are required to classify their leases as either capital leases or operating leases. Most companies classify their leases as the latter, which depict lease payments as month-to-month expenses in the income statement. Therefore, lease payments are considered rental expenses, and there is no asset or liability recognized on the balance sheet. This method has been criticized by users of financial statements because it fails to provide a faithful representation of leasing transactions.
Under the proposed accounting standard change, lessees will now have to recognize assets and liabilities for leases on the company’s balance sheet. The recognized asset will be the right to use the underlying asset, whether it be real or personal property. The recognized liability will be the obligation to make lease payments during the lease term. The proposal includes two approaches to accounting for the assets and liabilities of the lease for lessees: (1) if the lease term is for a major part of the economic life of the underlying asset or the present value of the fixed lease payments accounts for substantially all of the fair market value of the underlying asset, then the company must front-load the expense of the lease as a liability on the balance sheet (most equipment leases); or (2) if the lease term is an insignificant portion of the economic life of the underlying asset or the present value of the fixed asset payments is insignificant relative to the fair market value of the underlying asset, then the company must use a straight-line approach, which would allocate the lease payments evenly over the lease term as a liability on the balance sheet (most real property leases).
The proposal also includes two approaches to accounting for the assets and liabilities of the lease for lessors. Lessors will have to distinguish between leases to which the receivable, and residual approach applies and leases to which an operating lease accounting approach applies.
Once the final rules are adopted, the new accounting standard will increase financial liabilities reflected on balance sheets, forcing creditors, investors, business owners and others to reconsider the common calculations used to determine fiscal health. Standard fiscal covenants that will likely be affected include EBITDA and debt-to-equity ratios. Companies who currently have credit agreements or other financing arrangements — whereby the company has agreed to certain debt covenants in exchange for a line of credit or financing — may need to speak with their lenders and accountants in order to make sure that the new lease accounting standard will not automatically put the company in breach of its current debt covenants. If so, the company may need to engage legal counsel to renegotiate the terms of the debt covenants with its lenders.
As a result of the increased liabilities on a company’s balance sheet, there could be an increase in real estate and equipment purchases as opposed to leasing arrangements. At a time of record low interest rates and a diminution in property values, companies may seek to purchase assets as opposed to leasing.
The proposed lease accounting standard changes will be subject to a period of public comment prior to the publication of a lease accounting exposure draft in the fourth quarter of this year.
This column was co-authored by Brandon Purcell, an accountant for the Idaho State Controller’s Office and a Certified Government Finance Manager and Certified Fraud Examiner, and Matthew D. Purcell, an associate in the Business Group at the Boise office of Perkins Coie LLP.