05
Sep
10

Changes to Lease Accounting

My colleague Eric Wetterling just completed this great summary on some key proposed changes to Lease Accounting, and I wanted to share it with you.

Upcoming Changes to Lease Accounting

What is Coming

The FASB is working on a proposal draft for a change in the way leases are accounted for; moving them to the balance sheet from “off-balance sheet.”  The new standard will be written in conjunction with international accounting standards as a part of the FASB’s continued convergence project with international standards.

Current lease accounting allows for operating leases, where nothing is recorded in the balance sheet, and only the obligations are disclosed, in total, in the footnotes.  A reader of financial statements may not easily know the obligations and rights of the organization associated with leases.  The proposed standards would place all assets and liabilities associated with leases on the balance sheet, the face of the financial statements, and essentially do away with operating leases.

What to Expect

New Balance Sheet items

There will be an asset and liability each recorded on the balance sheet for both the lessor and lessee.  Upon initial recognition, the value of these would likely be the same.  It is to be expected that balance sheets will inflate for both assets and liabilities.  It will also make it appear as if companies with a large amount of leases are highly leveraged.

Lessor

Asset: Lease Receivable – Future payments that the owner of the asset would expect to receive.

Liability: Performance Obligation –Lessor’s obligation to allow the lessee to use the property.

Lessee

Asset: Right to Use –Lessee’s ability to use the property for a given period of time.

Liability: Lease Obligation –Amount that the lessee would expect to pay on the lease.

Rearrangement on Income Statement

Rent expense will likely be replaced, and will be recorded instead as amortization and interest expense,, moving, the expense out of operating expenses.  Essentially, leases will now be treated as leveraged assets, and thus amortized like assets.  Capital leases would likely see little change as they are already accounted for in a similar manner.

Additional Disclosures

Additional disclosures would be required in the financial statements in order to disclose the major assumptions used in the recording of the lease asset and liabilities.  Other disclosures could include a general description of each major lease and sublease, and reconciliation between opening and closing balances of lease assets and liabilities.

Benefits and Challenges

The primary benefit and motivation for this change in standard, is that it will make leases more visible to the users of the financial statements and present an accurate picture of the true assets and liabilities of the organization.  Currently, leases are too easily hidden “off-balance sheet.”

The primary challenge to this new accounting standard is that it will gross up both the assets and liabilities, resulting in little or no change to net assets yet making the organization appear that there is a large amount of outstanding debt.  This can affect financial ratios, and new benchmarks will need to be set when analyzing financial statements and debt agreements with financial covenants may need to be renegotiated.  The new guidance would also require the organization to make assumptions and estimates regarding uncertain future events such as the lease term, interest rates, contingent rental amounts, and residual values.

How to Prepare

Some suggestions for how an organization can prepare for this is to begin setting up systems and processes to analyze existing and new lease agreements, so that when the guidance takes effect it can be incorporated smoothly and easily.  Accounting models can be set up to concurrently account for this guidance before it takes effect so that the resulting change in the financial statements can be compared to current accounting and financial ratios and be updated to recognize this change.  Processes and procedures will also need to be developed to account for the leases on a monthly basis.

Conclusion

It is very likely that this guidance will be approved and standardized without significant changes.  The only question that remains is timing.  FASB has not released any information regarding when this guidance would come into effect, but the new standard will likely be issued in 2011.  This should give adequate time for organizations to prepare themselves for this upcoming change.

Eric’s summary is excellent and objective, and I should probably just let it stand as is. However I can’t resist adding a few editorial comments of my own.

I embrace and welcome FASB’s attempt to address off balance sheet liabilities. There have been multiple examples in recent years of the damaged caused by a lack of transparency of liabilities and risk, not captured in the balance sheet. Two obvious examples are Enron and the recent financial crisis.

But, I have some concerns with this proposed change. My concerns are not driven by an increased cost of implementation and compliance. While I have heard people suggest this standard will mean significantly more work, it is my experience that accounting professionals always raise to the occasion when implementing new standards. And, even if the change means more work, that does indicate if the change is good. Change is often simultaneously good, and a lot of work. No, my concerns are more conceptual.

First, conceptually I disagree that there in an inherent liability for the present value of all lease payments. In reality many (if not most) leases have early termination penalties. So, if my organization needs to exit a two year lease in month three, it is likely it will pay a penalty far less than the present value of the remaining months of the lease. If a liability exists it seems like it should be the lower of: 1) the lease exit costs or 2)the present value of future lease payments.

Second, the issue of encumbrances is not unique to leases. Many long term contracts carry stiff penalties for canceling the agreement. Neither these potential penalties nor the long-term costs of the contract are reflected on the balance sheet as liabilities. (A great example of this on a personal basis is cell phone contracts). Why should leases be different then other long term contracts?

Finally, I believe the role of accounting is to make financial information easy to understand for the rest of society. I think this new lease standard does not do that. There is a certain expression of surprised confusion most accountants make when they first hear the phrase “right to use asset”. Most accountants can move to understand the concept, but I believe that the concept will be a harder sell for society as a whole.

As US GAAP converges with IFRS, it is clear that lease accounting needs to change. FAS 13 is rule based, and confusing. But is this the right change?

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