Lease Accounting Update
An article by New York Institute of Finance accounting instructor Chris Broderick.
Welcome to my monthly update on US Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). As new accounting rules are discussed, adopted and implemented I will be providing you with a concise summary of how and when financial statements of public companies will be changing in response to the new rules. Your comments, experiences and examples are welcome additions to this discussion as I believe we can all benefit from hearing about issues related to accounting rules, how you deal with those issues and your opinions about changes to accounting principles.
This month I would like to outline the upcoming changes to Accounting for Leases that have been adopted by both US GAAP and IFRS.
Lease accounting as it has been used historically:
For years accounting for leases by both the lessee and the lessor was based on the principle of whether the benefits of ownership of the leased asset had transferred from the lessor to the lessee. Operating leases represented a rental agreement where the lessor was essentially still receiving the benefits of ownership, while the lessee was merely “renting” the asset. Most non-cancelable leases qualified as operating leases. Capital leases (also referred to as Financing leases) reflected that there was essentially a transfer of “economic” ownership of the asset from the lessor to the lessee and this transfer was reflected in the accounting as both the asset and the lease obligation was removed from the lessor’s balance sheet and put on the lessee’s balance sheet., not something the lessees really wanted to happen.
There were some differences between US GAAP and IFRS but the concept of operating and capital leases existed in both sets of standards.
As a result of these accounting standards lessees often preferred to have their lease classify as an operating lease to avoid capitalizing the asset and reporting the liability. Fortunately, disclosure in footnotes required details of the future obligations (cash rent payments) so a reader could ascertain the magnitude of upcoming cash outflows. Many analysts actually would take the future cash flows under operating leases and “capitalize” them on the balance sheet for ratio purposes.
Why were the accounting rules for leases changed?
The criticisms of the accounting rules centered on the sometimes significant off balance sheet obligations of operating leases, which many felt did not provide transparency to investors and analysts. Leases were actually structured to avoid capital lease accounting, a manipulation that did not reflect the economic realities of the situation. Additionally, since the world of analysts was already capitalizing operating leases, the accounting rules should reflect this. The thought by standards setters, the Financial Accounting Standards Board (US) and International Accounting Standards Board was to develop a standard that would put leases that are currently accounting for as operating leases on the balance sheet as capital leases. Companies in industries with significant operating leases, such as retail businesses and the real estate industry, opposed the possibility of this change.
What is the new accounting for lease standard?
Under the proposed “right-to-use” model all leases are to be treated as capital leases. While there are exceptions under US GAAP and IFRS to this model (certain natural resources, biological assets, service concession arrangements, et. al), the main exception is leases that are less than one year in length. Short-term leases may be accounted for as operating leases.
When will the new accounting rules be implemented?
The project on revision of lease accounting rules originated in 2006, with the exposure draft issued in 2010. An exposure draft outlines a proposed set of standards the standard setters have been working on. Comments on the proposal are collected and reviewed by the standard setters. Based upon these comments, the standard setters revise their proposals.
In 2011 the revised proposal was issued for further comment. The revised exposure draft is scheduled for the 2nd quarter of 2013. That draft will probably designate the end of 2013 for the final standard. Implementation however will probably not occur until at least 2016.
What will be the effect of the change in accounting standards?
There are many possible impacts of the proposed accounting standards, including:
- over $1billion in lease obligations will be put on the balance sheet of companies (US company estimate),
- probable breaches of financial covenants in existing loan agreements,
- more complicated accounting required by lessees,
- a possible increase in short-term leases,
- financial ratios and measures of performance will change as capital leases have a higher level of expenses early in the lease term than operating leases
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