by: Aaron Kaiser
This past August, the FASB and its international counterpart, the IASB, responded to criticism (from sources unnamed) of the presently constituted GAAP model for lease accounting, that the present accounting model (paraphrasing from the exposure draft) omits relevant information and fails to provide a sufficiently faithful representation of leasing transactions. The Boards recently issued an exposure draft of this proposed new accounting standard as the first stage of their joint project to address this presumed deficiency by developing a new approach to lease accounting, one that would address the criticisms and provide that appropriate assets and liabilities arising from leases be presented in the balance sheet.
The deadline for comments on the exposure draft is December 15; the Boards are expected to issue the new final standard sometime in 2011. The new lease accounting standard will constitute a major change from present GAAP and the results of its application will be very DIFFERENT looking financial statements for most companies. Will these differences result in a BETTER presentation? That’s yet to be determined.
It’s DIFFERENT; Is it BETTER?
It’s Different:
• It will cover substantially ALL leases of PP&E.
• If services are included in consideration, you will generally have to bifurcate elements.
• The basic concept referred to internationally as the “right to use model” will require the lessee to recognize an asset representing the right to use the leased item for the lease term with a liability for the rent to be paid. This is effectively a financing model whereby amortization/interest expense will be recognized in the income statement each year, instead of rent expense (how boring). Interest expense will be highest in the earliest years of the lease and will reduce as the related obligation is deemed “repaid,” so forget the “straight-line” concept of old.
• The new lease asset generally would represent the present value of the future lease payments as well as initial direct costs (i.e., commissions, professional fees, etc.) incurred to negotiate/execute the lease--the liability will be the NPV of the estimated future payments.
• Present value will be determined using the lessee’s incremental borrowing rate, or if readily determinable (not likely in real estate transactions) the lessor’s built in rate.
• Complications and subjective judgments will come into play in determining the expected term of the lease to use in the computations as that number may be a moving target (principles vs. rules again, so make a good guess preparers).
• Ditto with respect to such rental payments which in the bad/good old days used to be considered “contingent” such as CPI adjustments, percentage rent payments, other escalations; they all get included in the estimate of future cash outflows to be made at the inception of the lease. (And of course they will all require adjustment “true-up” to the actual facts as they occur. This is not going to be easy/fun to implement and maintain, neither for preparers of financials or for their auditors.)
• Lessor accounting (which we will not get into here) essentially follows the same concept as lessee accounting and will vary only based on whether the lessor retains exposure to risk/loss during or at the end of the lease.
• Special rules for subleases but conceptually similar accounting as would apply to prime leases.
• Presentation matters: The Boards proposed specially segregating related lease assets, liabilities, amortization expense and interest on the face of the financial statements, but has left this matter open to public comment (i.e., footnote disclosure only). Cash flows related to leasing will be in the financing section of the cash flow statement, separately stated.
• All kinds of expanded footnote disclosure will be required, arising chiefly because of all the subjectivity introduced by the accounting and the required truing up to reality which will be an annual task.
• Once the standard is adopted, it will be required to present information retrospectively for prior periods presented (that will require a good deal of work). Certain prior capital lease obligations will be exempted from the requirements.
• If /when adopted, this standard is likely to be effective in 2013 or 2014 so there will be time to deal with the changes
• By the way, it would be prudent for all of us in the real world to estimate the impact of this likely new standard on our financial statement ratios, debt covenant compliance, etc., including (please consult with counsel) the possible impact on what was presumed to be prior years’ compliance in the case of an after-the-fact retrospective presentation of previously reported amounts. Get ahead of the curve, start doing the work and prepare for the negotiations ahead.
Is it BETTER?
• The idea behind the proposal is to better converge U.S. GAAP with International Accounting Standards, the better to facilitate the ultimate goal of switching everyone to IFRS.
• In general, there seems to be a continued self flagellation among the GAAP standard setters that somehow our “rules” are inferior to the world’s “principles.” Is this really so?
• Under GAAP, there are all kinds of disclosures made with respect to required cash flows and payments to be made by those accounting for operating leases. Are the users of those financials somehow less informed by the “just the facts” approach to those executory obligations? Is something really lost by not having these items on the balance sheet? Is someone somehow mis/underinformed? I doubt it.
• From a lessor/landlord perspective, how does adding a new asset/liability to the balance sheet, while still retaining the historical cost model otherwise, add to improved representation of reality and transparency?
• In the name of theoretical purity, all kinds of subjectivity (and wherever there is subjectivity there will eventually be a misuse and scandal to come, trust me) will be introduced into what had heretofore been a straightforward if imperfect exercise
• It’s not just about leasing. The overriding accounting concept of principle vs. rule is going to create a minefield for preparers, users and auditors and we may yet find that we have achieved less comparability, at higher cost and without achieving appreciable clarity for the users of the financial statement information. I hope I am wrong, but 35+ years of practice suggests otherwise.
• At least the banks will be happy. They will get to extract their ounce or two of flesh for agreeing to accommodate the new accounting in the covenant calculations where there has been NO change in the underlying economics. The power of the pencil emerges triumphant (at least for some)!!
