White Paper: Lease Accounting: Get Ready for a Major Overhaul
by Jonathan Mangels
For the past decade, the Financial Accounting Standards Board (“FASB”) and the International Accounting Standards Board (“IASB”) have been working on a joint project to improve accounting standards and minimize the differences between US accounting standards set by the FASB and international accounting standards set by the IASB. One of the main areas of focus for this project relates to accounting for leases. After much debate, new accounting standards were issued in February 2016 bringing about a new era of lease accounting.
The primary change in the new lease accounting rules relates to lessee accounting for all leases (with a lease term greater than a year) as assets and liabilities. Currently, accounting rules only require capital leases, as defined, to be recorded on a company’s balance sheet. Most other leases are just accounted for in the income statement as rent and disclosed in the footnotes. Based on the old rules, a company can structure lease agreements so that they are excluded from a company’s balance sheet irrespective of the economic reality that they entered into an obligation that will need to be paid. Proponents for change argued that there is no difference between a lease payable to a landlord and a loan payable to a bank, yet in many cases a company would record a liability for a loan, but not for a lease.
Under the new standard, all leases with long-term commitments will be capitalized. Lessees will be required to record an asset for the right to use the leased item for the lease term. An asset will be recorded equal to the present value of the expected lease payments plus any upfront costs paid by the lessee less any incentives received from the lessor. A liability measured at present value would be recorded for the obligation to pay rent. After the initial measurement, the expense recognition will depend on whether the lease is considered an operating lease or a finance lease, as defined. Under an operating lease, the expense from asset depreciation and liability interest will be presented as a single line item in the operating expense section of the income statement. With a finance lease, the depreciation expense and interest expenses will be presented separately.
The new standard also addresses how to handle leases with contingent rent (e.g. rent based on sales volume) and options to renew or terminate. Under the new standard, a company will need to assess the value of such provisions upon entering a lease agreement and include this amount with the asset and liability being recorded on the balance sheet. Since the amount is an estimate and subject to change, the company may need to reassess the value at each future reporting period.
Other changes addressed by the new standard include sale-leaseback transactions, differences between lessee and lessor accounting, impairment issues, and additional disclosure requirements.
Although the new standard will make lease accounting more transparent and uniform, there will probably be some consequences that companies need to consider. One thing for sure is that the administrative time to account for leases will increase, both at implementation of the new standard and the future monitoring needed at each reporting period. Additionally, a company’s debt covenants may need to be restructured so that the new accounting does not create covenant violations, especially with debt to equity ratio covenants.
Opponents to the changes also argued that lease costs may increase under the new accounting rules. This is based on the assumption that lessees may want to shorten lease terms and exclude renewal options in order to minimize the effect on their balance sheets. The shorter lease terms and lack of renewal options would make it more difficult for lessors to earn their expected rates of return and, thus, they may need to raise lease rates.
The new standard is effective for public companies in 2019 and for private companies in 2020, however companies should start now to prepare for how the standards will impact their financial statements.