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One of the hottest topics in lease accounting today is the proposed changes to the current lease accounting standards. While FASB 13 (now ASC 840-10-05) has dictated lease accounting for as long as most of us have been around, the Financial Accounting Standards Board is hard at work rewriting the rules for leasing, starting with lessee accounting. The Board is addressing lessee accounting first because it sees off balance sheet treatment afforded to lessees entering into operating leases to be the most significant weakness in the current lease accounting standards. Complicating this process is the Board’s efforts to find a solution that will standardize these accounting rules with the International Financial Reporting Standards (IFRS).

Some lessors and brokers may wonder why they should be concerned with lessee accounting changes. First and foremost, leasing companies need to know how to structure and sell transactions that will be desirable to lessees. Many lessees will realize that the new rules take away the off balance sheet opportunity FASB 13 afforded them, and will, therefore, find leasing to be a less beneficial option. They may also see the new standards as being more cumbersome and complicated to account for and disclose. It will, therefore, become the challenge of every lessor and broker to find a new approach for selling leasing to these businesses.

Additionally, the new standards, as they are currently proposed, will require all operating leases to be capitalized on the lessee’s books, including real estate such as office space. That means that for those lessors and brokers renting office space, office equipment or other assets, this accounting change will affect their own financial reporting as well as that of their lessees.

Finally, it has not been determined one way or the other at this point, but the lessee accounting changes, may actually result in lessor accounting changes as well.

The new standards being developed will be based on a “right to use” model, meaning the lessee has a right to use the leased item. The right to use will be valued and recorded as an asset. The lessee’s obligation to pay rent will be recorded as a liability.

The obligation to pay rent is expected to be recorded at the present value of future rentals, contingent rentals, fees such as early termination or excess wear and tear fees, and residual value guarantees provided by the lessee during the lease term, discounted at the lessee’s incremental borrowing rate. The right to use the asset is expected to be recorded at “cost”, an amount equal to the present valued obligation to pay rentals. The question of whether this “cost” calculation reflects the actual value of the asset or its use does not appear to have been addressed.

Reassessment of the value of the obligation to pay rentals is expected to be performed at each reporting period and the obligation to pay rentals value will be adjusted, either with an offset to the right to use asset value or to profit and loss, depending on the cause of reassessment. Possible causes of reassessment may include a change in the lease term, a change in the most likely amount of purchase option or renewal, a change in the lessee’s incremental borrowing rate, or a change in the cost of a residual guarantee.

Once recorded, the asset is expected to be amortized or depreciated straight-line over the shorter of the lease term or the equipment’s economic useful life. Payment of lease obligations will be allocated to principal and interest. The interest portion, along with the amortization or depreciation of the asset, will replace rent expense.

A primary concern of this methodology is that the calculation of “rent expense” will not mirror the current straight-line recognition method. Due to the amortization of interest expense, rent will be accelerated in the early periods, thereby front-loading the expense deduction. For smaller leases this difference may prove immaterial, but for larger leases, may significantly impact the lessee’s bottom line. Additionally, the difference in accounting for the asset and liability will cause the balances in the related accounts to be unequal throughout the lease term.

Another area of concern is the changes that will result in ratios that may be used to evaluating a business’ credit potential. Restating a lessee’s financial statements once the change takes effect may result in a lower equity balance, and changes to various accounting ratios.

Items still unresolved include leases of immaterial items, short term duration (ie. less than a year) or non-core assets.

The result of this lessee accounting change is a greater compliance burden for the lessee; all leases will have a deferred tax component, will be carried on the balance sheet, will require periodic reassessment and may require more detailed financial statement disclosure.

A discussion paper regarding this standard change was issued, with a comment deadline of July 17, 2009. Although the comment period was a very short timeframe, over 300 comment letters were received. It is anticipated that an exposure draft will be issued, with comments to be received in 2010, and the final standard issued in 2011, with a 2012 or 2013 implementation date. It is anticipated that all leases will be required to be restated at the implementation date.

Today’s lessors need to keep informed and be proactive in developing new marketing strategies to encompass the new standards. Although the dust has not settled on the issues at this time, the challenge to sell leasing to those lessees who currently value the benefits of off balance sheet treatment is imminent.