Published July 2013

In March 2011, we advised that the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) were considering dramatic changes to the accounting rules for leases exposure draft issued in August 2010, after significant concerns were voiced by professionals across all industries.

After months of deliberation, the FASB and IASB jointly issued a revised, proposed accounting standards update on May 16.

The changes being proposed would significantly alter the accounting for leases, by bringing most leases that are currently expensed when paid onto a company’s balance sheet and by changing how the related expenses hit the income statement over the life of the lease.  Anyone reading a company’s financial statements, including owners, investors, bankers, etc. will be seeing the company through a completely different lens, and it will be very important to understand the nature of what will be changing, and how readers will view that data, to be able to understand the implications of those changes.

Proposed Accounting Changes on Lessees

There have been several modifications to the proposed lease accounting standards from the August 2010 to the May 2013 proposal, although the concept of recording most leases to the balance sheet has not changed. The proposed requirements would affect any entity that enters into a lease, with some specified exemptions and the proposed standard does not allow for any grandfathering of current lease arrangements.

The proposal separates leases into three distinguishable categories; Financing (Type A), Straight-Line Expense (Type B), and leases with a maturity of 12 months or less.  For leases with a maximum possible term (including any options to extend) of 12 months or less, a lessee could make an accounting policy election to apply operating lease-like accounting principles. Both Type A and Type B leases will ultimately be recorded to the balance sheet, increasing the perceived amount of debt that the company carries.

Financing (Type A) and Straight-Line Expense (Type B) Leases

Under Type A and Type B leases, a lessee would recognize the right-to-use the leased asset as an asset and a lease liability, initially measured at the present value of lease payments. If the Type A classification is used, the lease liability is amortized in a pattern in which the lessee expects to consume the right-of-use asset‘s future economic benefits.  If the lease has a Type B classification, the lease liability is amortized on a straight-line basis over the lease term.  As a result, Type A leases may cause more expense to be frontloaded toward the early years of a lease than is currently experienced.

Once a Type A or Type B classification has been determined, the lessee cannot change the election unless there have been significant changes to the contractual terms of the lease.  If the contractual terms and conditions of a lease are modified, resulting in a substantive change to the existing lease, a lessee shall account for the modified contract as a new contract at the date that the modifications become effective.

Additional Financial Statement Disclosures

The most significant change in financial statement disclosures is the requirement of a lessee to disclose a reconciliation of opening and closing balances of the lease liability separately for Type A and Type B. Those reconciliations should include the periodic unwinding of the discount on the lease liability and other items that are useful in understanding the change in the carrying amount of the lease liability.  The proposed accounting standards update does not require private companies and non-public nonprofit organizations to make this disclosure.

Going Forward

The FASB has asked for comments on the proposed lease changes by mid-September 2013, and hopes to begin redeliberations by the end of the year, finalizing a new lease standard in 2013 or 2014.  It is not presently known as to when a new standard would take effect, but we currently expect that it will transition in over a few years beginning with public companies.

Other Implications

Our clients often ask us what impact these changes might have on their financial statements.  A couple of the key considerations:

  • Capitalization of the right-to-use asset and related liabilities will for many companies change their balance sheet leverage.  Many of these companies will find that this change to their balance sheet leverage might impact how their bank views their ratios under debt covenants.  Measuring these ratios in advance of implementation, and renegotiation of ratios with their banks prior to the effective date of this new accounting standard, will help to avoid unintentional problems.
  • These changes will give rise to new differences between GAAP accounting and income tax accounting. Therefore, it will be important to also recognize the impacts to deferred income tax assets or liabilities on the balance sheet.

 

If you have any questions regarding pending changes in lease accounting, or if we can help you with an assessment as to the impact of this on your financial statements, please contact us.

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