The FASB Proposed New Standards for Lease Accounting -- A Moving Target
Where We Stand Now
For many years there has been a movement by the international community towards establishment of International Financial Reporting Standards (“IFRS”) as the uniform set of accounting principles to be followed by reporting companies worldwide. In the U.S., the Financial Accounting Standards Board ("FASB"), which is charged with promulgating U.S. accounting principles (so-called "U.S. GAAP"), has been collaborating with the IASB (their international counterpart) towards the goal of "converging" international and U.S. accounting principles with the ultimate goal of achieving global uniformity. It is within this context that one must view the pending changes in GAAP lease accounting: So why now? What's the problem? The "problem" with existing lease accounting as enunciated by its critics is that (i) it does not faithfully represent the economic reality of the leasing activities and (ii) it contains too many "bright line rules" as opposed to "principles." This later criticism has been the battle cry of the international set against U.S. GAAP in general. Perhaps there is some merit to the complaint, but mostly, U.S. "rules" started out as lofty "principles" which over time became more complex (as rules) as economic activity itself became more complex and transactions could be structured to achieve an accounting result.
In August 2010, the FASB promulgated an exposure draft on leasing, which set forth sweeping changes to the way substantially all leases were to be accounted for (to both lessor and lessee) under GAAP. It would completely overturn accounting practice in place for the past 35-60 years. For a "principled" standard, there were lots of rules, requirements, implementation problems, guesstimates, etc.
The reaction of the stakeholder community was quite interesting--generally negative, extensive and highly critical of the monumental implementation burdens (e.g., the requirement of both lessees and lessors to estimate contingent rents, lease term and other matters imposed at the inception of the lease including retrospective application) for both lessor and lessee as well as the requirement for both to record on their books both an asset and liability based on this guess. Perhaps chastened by this negative reaction, the FASB resumed deliberations over March and April of 2011 with a view to fixing the perceived problems.
It appeared that the Board was set to retreat significantly (particularly vis a vis real estate leases) from their prior stance of requiring an asset/liability be recorded; but then (again apparently due to the pressures of the international community) re-reversed themselves. So, as of this writing, it appears that we are headed for a somewhat lighter version of the prior exposure draft to be issued and adopted by the end of 2011, with implementation to be required by 2013 or 2014.
The conceptual holy grail of this standard will be that, from the lessee's perspective, the "right to use" model will be employed, whereby the lessee will record an asset representing the discounted present value of the expected future lease payments to be made under the lease, as well as a liability to make those payments. The asset will be amortized on a "systematic and rational" basis (mainly straight-line) while the liability would be deemed liquidated, as payments are made much like a mortgage debt, using the interest method. Even under a somewhat simplified model, the data capture and data gathering and analysis requirements will be somewhat burdensome. In most cases, lessors will most likely have similar accounting as lessees, particularly in real estate.
So where does the proposed standard stand?
As of the most recent FASB - IASB meeting (June 13 - 15, 2011 - The Boards are meeting monthly at this point, for example on July 13, 2011 they'll be discussing leveraged leases) these are the highlights:
As to leases in general
* Standard will cover substantially all leases of tangible property (except for certain mineral rights, intangibles and biological assets)
* All leases having a term greater than one year (including renewals) will be covered
* Subleases will be covered
As discussed, the lessee, at inception of the lease, will record an asset and liability representing the present value of scheduled rent payments and certain (but not all) contingent rents provided under the lease for the base term of the lease and any renewal periods which ab initio will be exercised either because of a serious economic incentive to renew or disincentive to not renew. The interest rate to be used generally will be the lessee's incremental borrowing rate.
The highlighted financial statement impacts on lessees as compared to current practice are as follows:
- Increased debt will adversely affect ratios such as debt/equity.
- Expense recognition (amortization of right to use asset, plus interest on the debt obligation) will be front loaded as compared to current practice, so net income will be reduced initially.
- EBITDA will be higher under this standard since amortization and interest are both below the line, whereas "rent expense" is above it.
FASB is still trying to decide between two approaches, as follows:
- The "performance obligation" approach will result in the lessor retaining the leased asset on its balance sheet, plus adding a new asset (and liability) representing the present value of the lease payments receivable and the "performance obligation" liability which could be likened to a deferred revenue concept. The receivable would diminish over time as rents are collected with a portion representing interest income and a portion representing payment of the receivable. The liability will be amortized to income over the lease term. The leased asset will be depreciated (U.S. GAAP), as under present practice.
- The second approach is the so called "derecognition" approach which would result in the lessor removing all or part of the leased asset from its balance sheet at the inception of the lease, recording revenue and cost of sales.
The Board has stated that the derecognition approach would be appropriate if the lessor has transferred risks of ownership and does not expect significant returns upon reversion of the property. Again, as is the case of lessees, the implementation of this requirement will, of necessity, change the periodic amounts of income, EBITDA and financial ratios of lessors as well.
Obviously, even though I have only outlined very basic principles here, there is going to be a significant amount of detail to be ferreted out and judgment which will be required by the issuers of financial statements upon implementation of these standards.
Companies -- both lessors and lessees -- will have a tremendous compliance burden placed upon them as a result of this new standard, including required analysis of all leases and determination of the impact of changes on financial covenants embodied in credit or other agreements, including possible retrospective application. Credit grantors will rejoice at fees they will earn to change existing agreements to comply with the new accounting.
The Take Away
Lessors and lessees need to keep an eye peeled on the standards when issued later this year. Companies will need to develop the appropriate data capture and systems in order to develop the recorded amounts and required disclosure. It will require a lot of work. Your CPA can be most helpful in this regard.
This article first appeared in the August edition of the Willis Group’s Real Estate and Hotel Practice Views.
This Just In…
In late July, the FASB and IASB decided to re-expose for comment the new proposed lease accounting standard before the end of this year. This means the new standard will probably not be issued until after Q1 2012.