Lease Accounting Update

Financial Executives magazine wrote an article that I thought did an excellent job of outlining the pending changes for lease accounting.  These changes are coming from the joint project between the Financial Accounting Standard Board (FASB) and the International Accounting Standards Board (IASB).  The article focuses on how the proposed new standards are expected to affect lessees. 

Currently, under GAAP, all leases are presumed to be operating leases unless it meets one of four criteria:

1. The lease transfers ownership of the property to the lessee by the end of the lease term
2. The lease contains a barb purchase option
3. The lease term is equal to 75% or more of the estimated useful life of the leased property
4. The present value of the lease payments is is equal to or greater than 90% of the value of the leased asset at the start of the lease

If the lease meets any of the above criteria then it is capitalized and placed on the balance sheet.

FASB issued its proposed standard on February 8th, 2013 with an intent on having a revised exposure draft out later this year.  In general, the proposed standard requires lessees to record as an asset and corresponding liability, the obligation to make lease payments over the term.  Under the proposal:

• All leases are treated as capital leases, except leases less than 12 months will be allowed to be treated as operating leases.  For capital leases, the lessee will record the obligations at the present value of the minimum lease payments, discounted either at the lessee’s incremental borrowing cost or the discount rate implicit in the lease.
• The proposal introduces the concept of a right to use asset, describing the nature of the asset the lessee has when it controls property it does not own.
• The new standard will also further define the lease term to include not only the initial non-cancellable lease term, but any renewal periods for which it is “more likely than not” the renewal period will be taken.

The proposed standard will require retroactive implementation.  I have read separately that final implementation may not be until 2016.  If so, and you report 2 or 3 years of comparative statements, you will want to starting thinking about how this change will impact your financial statements soon.  Also, depending on how many leases you have, this change could have a big impact on your balance sheet.  You should start discussions today with your lenders on how ratios in debt covenants will be calculated after new lease accounting standards go into effect.