MAJOR CHANGES TO LEASE ACCOUNTING

By | March 12, 2011

Major changes are being proposed for lease accounting and those entities that prepare their financial statements in accordance with generally accepted accounting principles (GAAP) should be monitoring the changes that are being proposed.  The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) initiated a joint project in 2010 and issued an Exposure Draft which would essentially create a single accounting model for most leases and would require the recognition of lease related assets and liabilities on the balance sheet. Currently most leases (particularly those leases that involve property) qualify as operating leases and leases payments arising from these leases are generally accounted for in the period that the payments are made.  The proposal would require recognition of assets and liabilities arising from these leases. The proposal is written to apply to both lessors and lessees but the emphasis has been directed to lessee accounting because of the concern that significant liabilities associated with operating leases have not been recognized on the balance sheets of the lessees. Several hundreds of comment letters have been submitted by interested parties expressing concern about the complexity and subjectivity of many of the proposed changes. The FASB and the IASB are reviewing these concerns and are considering modifications to the proposal in an attempt to address some of the concerns. But both boards have expressed their commitment that the vast majority of leases be recognized on the balance sheet.

WHY BE CONCERNED ABOUT THESE CHANGES?

Although lease accounting under current requirements can be extremely complex, a lease arrangement can now be structured as an operating lease which results in off-balance-sheet treatment by both lessors and lessees.  This treatment has been the subject of long standing criticism (particularly with respect to lessees) since it allows a legal “obligation” to escape recognition on the balance sheet. The current proposals would require the virtually all leases be recognized on the balance sheet resulting in significantly more calculations requiring judgment and estimation, the potential need for extensive changes to information systems and much larger liabilities on balance sheets which could result in a need for renegotiation of financial covenants associated with loan agreements. Recent surveys that have been conducted to assess the impact of these potential changes have produced the following feedback:

  • Implementation will require a major undertaking with a significant percentage of responders indicating that they are not prepared for such an undertaking;
  • There will be a significant impact on the debt to equity and other financial ratios which could impact debt covenants;
  • Financing may be more difficult to obtain because of additional scrutiny by lending institutions
  • There may be a tendency to enter into shorter term leases in order to reduce the liabilities that will have to be recognized and this may result in increased rent in order to recoup upfront investment;
  • There was significant concern expressed about the completeness and accuracy of existing lease data and the ability of existing technology systems to comply with the new standards.

WHAT SHOULD INTERESTED PARTIES DO AS NEXT STEPS?

As indicated earlier, there has been significant concern expressed as to the extent of the changes being proposed and the complexity of these changes. It is clear that there will be revisions (possibly major revisions) to the provisions of the original Exposure Draft. However, the fact that the Boards have committed to a balance sheet recognition approach to lease accounting would seem to indicate that major accounting changes will be forthcoming in some form. It is extremely important that interested parties monitor the progress of the discussions and general implications that might result for their particular organizations. The Boards have indicated an intention to have a final document issued by the summer of 2011. There has not been any firm implementation date proposed at this point but there has been speculation as to 2013. Additionally and importantly, existing leases would not be grandfathered so that assets and liabilities with respect to existing lease portfolios would have to be recognized as of the date of initial application. Although that may seem to leave sufficient time for analysis, the amount of work to be performed will be significant and time consuming. 

Referring back to surveys that have been conducted, one finding that is particularly disconcerting is the concern over the completeness and accuracy of existing lease data and the ready ability to access this type of information. Regardless of new accounting pronouncements, it is crucial that both lessors and lessees have this information complete, up to date and readily available. Therefore, we would recommend that leases abstracts be prepared or reviewed to ensure that they contain all the critical information that is necessary both to monitor the portfolio and to accumulate the data that might be necessary to accommodate the new accounting requirements. This aspect of the effort is clearly not a waste of time – this is critical data that should be in place. We can provide a lease abstracting tool that will facilitate the preparation and accumulation of this information. We can also provide assistance in completing this task.

The Boards meet periodically to discuss the progress of this project and make decisions about changes to the provisions of the Exposure Draft. We will update you periodically as to the progress and the decisions that are made.