The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) continue to deliberate over changes to existing lease accounting standards, which could bring an estimated $1 trillion of lease obligations onto businesses’ balance sheets. Capitalizing these obligations, which are currently being expensed as operating leases, has the potential to negatively impact a company’s financial position and put businesses in default of their debt-to-capital loan covenants.
The joint project of the FASB and IASB to make accounting for leases more consistent and transparent began in 2006. In 2010, the boards issued an exposure draft containing sweeping changes to current lease practices.
As a result of nearly 800 comment letters received on the initial proposal, the boards have been reconsidering significant aspects of the guidance, including lease definition, lease term, income statement effects, and lessor accounting. Specifically, the boards are reassessing their tentative decision to have lessees recognize interest expense using the interest method and separately amortize the right-of-use asset on a straight-line basis, the effect of which is to accelerate total lease expense recognition in the early years of the lease. The boards are also taking another look at the income statement effect on lessors who, under the proposed receivable and residual approach, would recognize profit upon commencement of the lease.
While the boards are not considering changes to their proposed requirement for lessees to recognize a right-of-use asset and a lease liability on the balance sheet or to recognize interest expense using the interest method, the boards are considering amortization methods other than a straight-line approach, in an attempt to smooth out the total lease expense over the lease term. The amortization methods being considered would essentially push more amortization expense to later years of the lease, and, coupled with the decreasing interest expense over the life of the lease, would result in a consistent amount of total lease expense each year. The downside of this proposal is that the accounting for lessees would most likely become more complicated, involving more estimates and judgment to determine the most appropriate approach to expense recognition.
Lessor accounting issues associated with the proposed lease standards include the capitalization of initial direct costs (costs directly attributable to negotiating and arranging a lease that would otherwise not been incurred), and determining the discount rate, which could be the lessee’s incremental borrowing rate, the rate implicit in the lease, or the yield on the property (in the case of property leases). Lessors also would be required to identify and account for lease and non-lease components separately, and allocate lease receipts accordingly. If the lease contract contains renewal or purchase options, the lessor is to include the exercise price of the option in the initial measurement of the lessor’s right to receive lease payments, if the lessee has a significant economic incentive to exercise the option. The lease proposal also exempts investment property from the receivable and residual approach, and instead indicates that the lessor of the investment property would recognize only the asset and any accrued or prepaid rental income on its balance sheet. For investment property, net income would generally be recognized straight-line throughout the lease term.
In a letter dated May 22, 2012, 60 members of Congress (37 Democrats and 23 Republicans including Moore, Kind and Petri from Wisconsin) expressed their concerns over the proposed changes in lease accounting standards, warning the FASB of “disastrous consequences” for U.S. companies and the real estate industry if the proposed changes are approved, and urging the FASB and IASB to conduct an in-depth economic impact study of the costs of the lease accounting proposal prior to its finalization. The congressional letter articulates concerns over slower job creation and higher costs of accessing capital, if the proposed changes are implemented.
At this point, the boards have decided to conduct further outreach and research before making any decisions. As a result, the second exposure draft on leases, which was expected to be issued during the first quarter of 2012, has been delayed until most likely the fourth quarter of 2012. As there are no grandfathering provisions planned, all existing leases will need to be recorded in accordance with the new standard. The new lease standard is expected to become effective for privately-held companies no earlier than annual reporting periods beginning on or after January 1, 2016; in other words, effective for December 31, 2016 year ends, with retrospective (restatement of all years presented) application required.
Schenck will continue to provide further updates on the accounting for leases as developments occur.