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May 31 2011

Issues to Consider as One Prepares for the Financial Impact of Lease Accounting Changes (May 2011)

The effective date for implementation of the changes to accounting for leases may be a few years away but it is not too early to prepare for these changes, especially as one considers the impact on key financial analysis metrics and ratios. It is important to consider how these changes, which may be significant, should be disclosed and explained to users of financial information.  The following significant metrics will be impacted by these changes once they become effective:

  • Total assets
  • Total debt
  • Total liabilities
  • Total equity
  • Net income
  • Interest expense
  • Amortization expense
  • EBITDA
  • Debt coverage ratios
  • Interest coverage ratios

The following is an example of the type of disclosure that should assist users of financial statements and other financial information to understand the effect of the lease accounting changes.

In _____, 2011, the FASB and IASB issued a new accounting standard which changed the manner in which lessee account for lease liabilities. Previously, leases were classified as either capital/leveraged or operating leases. Capital or leveraged leases are accounted for as acquisition of an asset and the incurrence of a liability with the asset and liability being reflected on the balance sheet of the lessee. Leases classified as operating leases have neither an asset nor liability recorded on the balance sheet and rental payments are reflected as rental expense in a systematic manner, which is usually straight-line.

The new accounting standard is effective for fiscal years beginning after January 1, 201x. Under the new standard, all leases are required to be reflected as financings on the balance sheet of the lessee as an asset (Right of Use asset) and a liability (Rental Payable). Under the financing concept, the lessee recognizes interest expense on the Rental Payable using the interest method and separately amortizes the Right of Use asset, generally on a straight-line basis.

Prior to the adoption of the new accounting standard, all of the Company’s leases had been classified as operating leases. In conjunction with the adoption of the new accounting standard, the Company is required to recognize and measure all leases outstanding using the provisions of the new accounting standard. The effect of the new standard is the increase the amount of assets and liabilities accelerate the recognition of expense associated with leases and convert what had been rental expense into a combination of interest and amortization expense.

The effect of the adoption of the new standard on the Company’s total equity is as follows:*

Equity as previously reported                          $ xxxxxxxx

Effect of adoption of new standard                 (xxxxxxxx)

Equity as reported January 1, 201x               $ xxxxxxxx

 

The suggested disclosure noted above is for discussion purposes only. The specific disclosure should be tailored based upon the provisions of the new standard once it is finalized and the particular conditions of each company.

*This disclosure is for illustrative purposes only and should be modified or expanded based upon the individual circumstances of each company.