Financial Services Insights - Nov 2010 - Lease Accounting Changes
On August 17, 2010, the Financial Accounting Standards Board ("FASB") and the International Accounting Standards Board ("IASB") jointly issued an exposure draft ("ED") on Topic 840 Leases for public comment. The ED is scheduled to remain open for public comment until December 15, 2010.
Current accounting guidance requires lessees to classify their lease obligations as either a capital lease or an operating lease. Although many concerns have been identified under existing lease guidance as it relates
to operating leases in the financial statements of the lessees, the ED addresses the accounting treatment for both the lessee and lessor and eliminates the concept of operating leases.
For lessees under a capital lease, the leased asset and the corresponding liability is recorded on the lessees' books. Under an operating lease, the leased asset and the corresponding lease payments are treated as off-balance-sheet items and only a deferred rent liability (i.e., a timing difference between the actual lease payments and the average monthly lease payment), if applicable, is recorded. Consequently, the recording and disclosure requirements for operating leases fail to address the true economics and obligations of the transactions. Many financial statement users need to adjust the amounts present in the statement of financial position to adequately reflect the assets and liabilities associated with operating leases. The ED develops a new approach to lease accounting that would ensure that the assets and liabilities coupled with the related income and expense components associated with the lease transactions are adequately recognized in the financial statements.
For lessors, the ED would require the lease transaction to be accounted for under one of two methods: the performance obligation approach or the derecognition approach, depending on the exposure to significant risks and benefits.
IMPACT ON BUSINESS
The following are significant changes for lessees proposed in the ED:
- Recognizing a right-of-use asset and a lease obligation liability replaces the "off-balance-sheet" and lease classification concept (i.e., operating vs. capital lease).
- For transactions previously recognized as an operating lease, rent expense will be replaced by amortization and interest expense. The amortization expense of a right-of-use asset will be amortized on a straight-line basis while interest expense will be front- end loaded (i.e., accelerated).
- When determining the lease obligation liability, lessees calculate the present value of expected future lease payments. Lessees also need to consider contingent rentals and residual value guarantees in their liability assessment. The term of the lease used in the assessment is based on the probability of lease renewal periods on the longest possible term that is more likely than not to occur (i.e., greater than 50% chance of occurring). For lease terms that do not exceed 12 months, calculating the present value of future lease payments is not required.
- For each reporting period, the lessees would need to re-evaluate its estimated liability of contingent rentals and value guarantees should new facts and considerations become apparent.
The statement of financial condition for transactions recognized as an operating lease would have a change in landscape under the ED. Assets and liabilities will be grossed up which may have a significant impact on financial statement ratios (e.g., leverage and capital ratios), even though cash flows and business activity will remain unchanged. Additionally, recording the right-of-use asset and corresponding lease liability could have an impact on Broker-Dealer 15c3-1 net capital computations.
Under the ED, transactions recognized as operating leases will also have an impact on the statement of operations under the ED. Instead of rent expense being recognized on a straight-line basis under the current standards, amortization of right-of-use asset and interest expense will be recognized over the term of the lease. Interest expense would be skewed toward the initial periods making expense recognition accelerated. Another element to consider is the re-evaluation of the lease liability every reporting period, which may add volatility to net income/loss. This change will also have an impact on financial statement ratios (e.g., interest coverage ratio) and measures of EBIT and EBITDA.
The cash flow statement will undergo a change as well. Under the current standard for operating leases, cash outflows for lease payments are defined as an operating activity. Under the ED, cash outflows for the lease payments will be defined as a financing activity.
For leases currently be treated as capital leases, the impact on the balance sheet and income statement would vary based on the terms and economics of each respective lease agreement.
The following are significant changes for lessors proposed in the ED:
- The ED provides two accounting models for lessors. The performance obligation approach and the derecognition approach. If the lessor maintains exposure to significant risks and benefits of the transaction, then the performance approach is used. Otherwise, the derecognition approach is used.
- For determining if the lessor has exposure to significant risks and benefits, the lessor should consider the following:
- During the lease term:
- Contingent rentals based on the use or performance of the underlying asset
- Option to extend or terminate the lease
- Material non-district services as defined in the lease
- After the expected lease term:
- Is the expected lease term significant to the remaining useful life of the underlying asset?
- Is a significant change in the leased asset value expected at the end of the lease term taking into consideration the present value of the underlying asset and residual guarantees
- Under the performance obligation approach, the leased asset will remain on the lessor's books.
A receivable for expected lease payments and a corresponding performance obligation liability would be established.
- Under the derecognition approach, a portion of the leased asset would be removed from the books. A receivable for expected lease payment (includes income) and the residual asset representing the rights to the leased asset is recorded. Expense would
be recognized for the portion of the asset that is removed from the lessor's books. Income and expense may be presented net.
If the ED evolves into an Account Standard Update (ASU) on Topic 840 Leases, lessees and lessors will need to assess impact of the new standard on their business. The impact to the reporting entity is significantly dependent on the lessees or lessors leasing business activities and on the complexity of each respective lease agreement. As currently drafted, initial adoption of the proposed standard will also require retroactive reporting. Some areas of focus an entity should address in anticipation of the issuance of the ASU are:
- Reporting and disclosure requirements
- Regulatory compliance (e.g., net capital computation 15c3-1)
- Impact on existing contractual agreements
- Management of lease terms and provisions
- Accounting procedures, processes, and software to handle the complexities in determining the effect of changes in lease assumptions
- Documenting the internal controls and processes
- Tax implications
Financial Services Insights - November 2010