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Debate over controversial lease accounting changes has ripple effect

10:34 am, July 3, 2013

By Edward Ichart, CPA, Partner,
Shahab Moreh, CPA, Partner-In-Charge,
WeiserMazars LLP

EDWARD ICHART

The new proposed accounting standard related to accounting for leases has been the subject of controversy and criticism from landlords, tenants, other lessors and lessees of all types since originally proposed in 2010. Most businesses enter into lease arrangements as part of their normal operating activities.

These leases are currently “off” the balance sheet as they can be classified as operating leases under current accounting principles generally accepted in the United States of America (“GAAP”) and as such, neither an asset nor a liability are presented.

The Financial Accounting Standards Board (“FASB”) had taken the position that leases convey valuable rights and obligations that should be reflected “on” the balance sheet so users of financial statements have transparent information about the obligations of a business related to its leasing activity.

This received a great deal of criticism, because it requires assets and liabilities arising from “all” lease contracts to be recognized. Due to the numerous comment letters received on the 2010 proposed Accounting Standards Update: Leases, and the deliberations that occurred over the past three years, the FASB on May 16, 2013 issued a substantially revised, essentially an entirely new Exposure Draft (“ED”), which, if it becomes effective, would significantly change the accounting treatment for many leases.

For those that ultimately may be impacted, it is very important to become aware of the changes proposed and how they will modify current GAAP.
The ED defines a lease as a contract that gives the lessee the right to use and control a specified asset for a period of time in exchange for consideration. If the contract does not specify the asset, the contract is not a lease. Short-term leases for a period of 12 months or less are not affected by the new proposed rules.

Leases would be required to be classified as either Type “A” or Type “B.” Type “A” leases generally apply to something other than real property, such as tangible personal property like vehicles, machinery, aircrafts, and other equipment.

Type “A” leases are assumed to be for a significant part of the asset’s total economic life or the lease payments are significant compared with the asset’s fair value.

In the rare instance where tangible personal property is leased for a term that is an insignificant part of the asset’s economic life or the present value of the lease payments is insignificant compared to the asset’s fair value, the lease should be classified as a Type “B” lease.

Type “B” leases are generally for real property or a portion thereof.

SHAHAB MOREH

Type “B” leases assume that the lease duration is not for the major portion of the asset’s remaining economic life and that the lease payments do not account for substantially all of the real property’s fair value.

Also, in those rare instances when real property is leased for a term that is the major portion of the asset’s remaining economic life or the lease payments account for substantially all of the asset’s fair value, the lease should be classified as a Type “A” lease. The latter may be the case for many “ground leases.”

Both Type “A” and Type “B” leases would be recorded on the lessee’s balance sheet as a right of use asset and a liability.

The amount recorded would initially be the discounted present value of the lease payments required by the lease agreement.  The rate used to discount the payments would be the rate that the lessor charges, if known, or the lessee’s incremental borrowing rate.

Non-public entities would be permitted to make an accounting policy election to use the risk-free interest rate. The term of the lease would be the stated noncancelable term excluding any option periods, except if there is a significant economic incentive for an entity to exercise or not exercise the option.  The lease payments would exclude any variable payments that the lease may provide for such as payments based on a percentage of sales, but would include any that are based on an index such as a CPI.

Type “A” leases would have interest and amortization expense reported on the entity’s statement of income rather than rent expense. Since interest is always higher in the early years, as the outstanding debt is higher, total expenses for Type “A” leases will be higher in the earlier years and lower in the later years of the lease.

Type “B” leases will have rent expense reported on the entity’s statement of income in a straight-line manner, similar to current presentation.
Lessees would see a significant change to their balance sheets because both an asset and a liability would be recorded.

Depending on the lease term, the liability may be significant in relation to the total amounts of assets, liabilities, or net equity reported on the entity’s balance sheet. Some lessees are already discussing the effects of these potential changes to their balance sheets with lenders, as many loan agreements have financial covenants that may be significantly impacted by the new rules.

It is probable that many entities will fail covenant testing if the ED becomes effective. Lessees of real property may reconsider their leasing arrangements if the ED becomes effective and large amounts of liabilities are recorded on their balance sheets.

Some in the industry believe the new rules will impact the real estate business by incentivizing lessees to enter into shorter term leases in order to reduce the amount of debt on their financial statements. The shift to shorter term leases could be viewed as increased credit risk to landlords.

The revised rule does not make significant changes for lessors of real property. Unlike the previously issued Preliminary Views and Exposure Draft, this ED no longer requires landlords to record a contra-asset for their obligation to provide space and record a lease receivable representing its right to receive rental payments from the tenant.

The FASB changed their proposal based on the significant criticism that the prior proposals generated.

Interested parties can respond to the FASB’s proposal before September 13, 2013. It is expected that a final pronouncement will be issued during the early part of 2014.

Although no effective date was mentioned, it is likely there will be a delay in making the new rules effective in order to give companies time to comply with the new rules and to allow them to renegotiate their loan agreements that contain covenants limiting their debt amounts.

The ED proposes a modified retrospective treatment, which would mean that the financial statements for all periods presented, for entities that present comparative financial statements, would be adjusted to present the new treatment of leases. Therefore, for many entities, leases that currently exist or are being negotiated would have to be reported on the balance sheets of lessees.

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  • George Azih

    I actually agree with the proposal by the boards. It eliminates the incentive
    companies have under the current guidelines to “tinker” with the
    numbers in order to get off-balance sheet treatment.

    George Azih

  • persia samovar

    You gentlemen explained the proposed changes so well! Thank you. These rules are quite fair to all parties and lead to better insight into the true condition of a business. As to the issue of some businesses being in violation of loan covenants when the proposed changes take effect, their non-compliance should be “grandfathered” in, as the new rules were beyond their control.