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Friday, June 15, 2012

Standard Change: FASB and IASB to Issue New Approach to Lease Accounting

Nearly all businesses are involved in leasing – from heavy industrial equipment and shipping containers to office copiers and office space. Up until now, accounting for these leased assets has been fairly straight forward but that is changing. In the following article, Armanino Partners Paul Peterson and David Davis discuss the coming changes in lease accounting and give tips on how to strategize to meet the challenge of this coming change.

When accounting standard setters decided in 2009 to revisit lease accounting, it wasn’t a small thing: leasing is so pervasive in the global economy that a change in standards is bound to affect a large majority of all businesses.

In 2009, the Financial Accounting Standards Board (FASB), in collaboration with the International Accounting Standards Board (IASB), released a discussion paper proposing new principles for lease accounting that included the requirement to place virtually all leased assets on the balance sheet along with a corresponding liability. In 2010 the two standard setting organizations released an exposure draft and received many comments. A revised exposure draft is expected to be released within the next year and will include proposed effective dates. There will likely be a 120-day comment period with an effective date for public entities no earlier than 2015. A final pronouncement is expected in 2013.

Regardless of whether the process is completed sooner or later, it won’t be much longer and so a heads up for financial decision-makers is necessary now. This is the time to contact your accountants to discuss how to manage what could be a challenge for many businesses, particularly those in manufacturing, shipping, construction and other industries that rely on heavy equipment and which lease that equipment as a financing vehicle.

Here are three key areas of concern from the proposed new standard that we think businesses should be aware of as they anticipate this coming change in standards for lease accounting:

Balance sheet recognition – Right now, if you lease a piece of equipment with a 10-year life for a five-year period, it is classified as an operating lease, which means you expense monthly payments and no asset or liability appear on your balance sheet.

Under the new proposed standard, that same lease would be considered a “right-of-use” asset and will have to be booked as both an asset representing the entity’s right to use an underlying asset during a lease term; and as a liability representing a contractual obligation to make lease payments for a defined term (a debt obligation).

The consequences of this could be significant. For example, if you borrow money from a bank, you have loan covenants which likely stipulate that you maintain a specific debt-to-equity ratio (or range). Booking new debt obligations based on this potential change in the standard could cause loan covenants to be broken and expose you to higher interest, fees and penalties and possibly a calling of your loan(s).

Retrospective from original lease date – The proposed standard requires lessees to record right-of-use lease assets and lease payment liabilities retrospectively, meaning that the prior year balance sheet(s) and opening equity balances must be adjusted as if the new accounting policy had been applied from the beginning of the earliest period presented. This requires calculating the value of each lease contract that was in effect during any of the periods presented in your financial statements.

Treatment of derivatives – Previously, leases were excluded from the requirements of derivatives accounting rules. Soon, you likely will have to disclose all potential embedded derivatives associated with leasing such as buyout options, lease payments or cancellation clauses indexed to a benchmark of some sort. Questions arising from this standard in exposure drafts and meetings revealed some confusion; for example about how to discount future cash flows to come up with an accurate obligation and for what time period? One leased asset could have several derivatives associated with it and so we can see the amount of complexity accounting for leases under the proposed standard could present.

Other Ramifications
There are ramifications of these changes for businesses that are lessees, lessors, or both. For lessors, the standard setters are considering the receivable and residual approach and have tentatively decided that for all lease contracts within the scope of that approach, a lessor should:

  • Initially measure the right to receive lease payments at the present value of the lease payments, discounted using the rate charged the lessee and then measure at amortized cost applying an effective interest method.
  • Initially measure the residual asset as an allocation of the carrying amount of the underlying asset.
  • Subsequently measure the gross residual asset by accreting to the estimated residual value at the end of the lease term using the rate charged to the lessee.
  • Present the gross residual asset and the deferred profit together as a net residual asset.

Right now, it appears standards will be somewhat different for leveraged leases, subleases and so forth. Leases that are likely to be exempted from the new standard are those for the right to explore for or use minerals, oil and natural gas; and leases of biological assets, including timber. The standard setters are currently analyzing whether leases of internal-use software will be inside or outside the scope of the new standard.

Now, here are a few suggestions on how to manage this coming change:

Familiarize yourself with the issues – Many companies have no idea that this debate is drawing to a close and that changes will be put forth sometime in the next year. It is a good idea to attend some of the live, free discussions by FASB and IASB, which are televised and streamed online. There is also information available from accounting associations like the AICPA or CalCPA.

Analyze your business – Inventory all your leases. If you are a lease-heavy business or in manufacturing or extractive industries, look through your lease contracts to determine the potential scope of what will certainly be a significant accounting project. Also look for embedded derivatives in your lease contracts. This will give you an idea of what you’re up against in terms of the size of the project, the amount of resources that must be put toward it, and an idea of how long the project will take.

Assess capitalization threshold – Review your capitalization thresholds. Setting a more reasonable threshold could result in reducing the time spent on insignificant lease contracts.

Contact your banks – It is always better to give your bankers a heads-up when extra debt is likely to hit your balance sheet. If you make contact early, your bankers will likely be much more willing to allow you to renegotiate loan covenants or waive fees.

Work with your accountants – If you have a large internal finance organization, you may have the bandwidth to put staffers on this project. But it will be complex and fairly labor intensive. At the risk of sounding like sales people, we do think that third-party accountants have the skills, knowledge and tools to make this transition easier and to help ensure your staff can continue to do their daily work.

Investors and analysts have always wanted leases to appear on balance sheets. FASB Statement No. 13, adopted in 1976, was a compromise that has lasted almost 40 years and had clear tests to differentiate operating leases from capital leases. In the not too distant future, however, these long-running principles will change in ways that will require a focused response.


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