Accounting & Auditing

The financial world has watched closely as the accounting standard setters—the U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB)—made clear their intention to converge guidance changing the way companies report one of the most basic financing arrangements:  leasing. Lease accounting has long been the poster child in the “rules-based vs. principles-based standards” debate. The revised guidance will apply to all entities other than governmental organizations. On August 17, 2010, the standard setters proposed major changes in the way both lessees and lessors account for leases.

All lessors and lessees will need to pay attention to the proposed rules because the final standard is likely to affect both the complexity of underlying accounting and the overall strategies related to asset portfolios and leasing as a financial tool. Estimates indicate well over $1 trillion in lease-related assets may be added to financial statements as a result of this proposed standard.

The changes resulting from this standard may have effects not immediately apparent because of the recognition of new assets, liabilities and changes in income statement presentation and resulting performance measurements, such as earnings results, valuations, leverage, debt covenants, budgeting, cost-plus pricing contracts, management performance arrangements and contingent payments based on generally accepted accounting practices earnings.

Lease accounting significantly impacts retail, airline, railway and equipment companies and others that have substantial existing or future leasing needs, or those that sell through leasing arrangements. Leases for intangible assets, biological assets and mineral rights, i.e., oil and gas, are generally excluded from this proposed standard.

In addition to BKD materials, the FASB and IASB websites will be your best resources for the detailed discussions surrounding these topics and project implementation status. Materials available as of the issuance of the exposure drafts include the drafts themselves along with press releases, podcasts and webinars, summary documents and information leading up to the drafts, such as discussion papers and preliminary views documents.

If you have followed this project closely from the discussion document through board deliberations, there are few surprises in the exposure drafts. BKD has issued several articles relevant to leases that can be found on our website, such as:

• Proposal Would Make Significant Change in Lease Accounting
• Equipment Lease vs. Purchase Considerations for Contractors
• Proposed Lease Accounting Change Could Impact Your Credit

The FASB and IASB exposure drafts are roughly 60 pages each of relatively consistent material, with another 60 pages of background serving as the basis for conclusions in the documents. Complete reading of these documents and the final standards when published, as applicable, will be important for those responsible for implementing the new standards. Following are some highlights relevant to the new exposure draft:

• Both FASB and IASB provide a comment period to solicit input from the public and evaluate appropriate changes prior to issuance of a final standard. Comment letters submitted to FASB or IASB will be evaluated by both organizations if received in writing by December 15, 2010. Refer to the drafts for submission instructions or contact your BKD advisor to discuss. Note that comment letters will be posted to the FASB and IASB websites as received and can often provide insights into how others are evaluating or challenging the standards.
• FASB published an eight-minute podcast, and IASB hosted two 33-minute webcasts in conjunction with the issuance of the exposure drafts, accessible on the respective websites. The FASB podcast is a summary similar to the two-page summary document available on the website. IASB’s two webcasts, held on the same day, recap the board’s views for the first half of the webcasts but have differing audience questions in the second half. These question-and-answer sections provide additional information but are addressed from an international perspective, so U.S. financial statement users should be cognizant of potential differences in application.
• The basics of the new model in the exposure drafts address two complaints about existing leasing models:
• Inconsistency in recognition between the U.S. and other countries and in delineation between operating and capital leases that is sometimes achieved based on small contractual differences
• Omitted obligations and related leased assets from the balance sheet for any operating leases, motivating transaction structuring to obtain an accounting result, not necessarily the highest economic benefit

Key provisions of the proposed standards are:

Lessees

• Off-balance-sheet accounting for most leases is eliminated. All assets and obligations for operating leases would be brought onto the balance sheet.
• The resulting assets and liabilities would initially be recorded at the discounted present value of the required payments.
• Rent expense for operating leases would be replaced by amortization and interest expense. Asset amortization will generally be on a straight-line method, while interest will be recognized on the effective yield method, which will “front-load” the cost.
• Lease terms would include renewal periods that are judged “more likely than not” to be exercised. Currently, only those reasonably assured by bargain renewal options or economic penalties are included.
• Lease payments would include contingent amounts based on a probability-weighted approach. Currently, contingent rents are recognized in the period they occur.
• Renewal periods and contingent rents would be continually reassessed and changes recognized as changes in estimates. Currently, changes in these estimates are not recognized unless the lease is modified.

Lessors

The proposed standard includes two models for lessors. Lessors apply the performance obligation approach if they retain significant risks or benefits related to the underlying asset. Otherwise, they apply the derecognition approach.

• Under the performance obligation approach, the lessor recognizes a lease receivable, the right to receive future rental payments, and a performance obligation, the obligation to allow the lessee to use the asset. Essentially, the performance obligation represents deferred revenue. In this case, the carrying amount of the leased asset remains on the lessor’s balance sheet.
• Under the derecognition approach, the lessor recognizes a receivable and revenue for the right to receive future lease payments. The carrying amount of the leased asset that is considered to be transferred is derecognized from the lessor’s balance sheet.

Companies with significant operating-lease portfolios will be most affected if the proposal is adopted. Significant increases in assets and liabilities on the balance sheet could result in lower turnover ratios and return on capital and an increase in debt-to-equity ratios. Loan covenants may need to be rewritten to accommodate the changes or companies may face inadvertent covenant violations.

The elimination of off-balance-sheet accounting would fundamentally change the accounting element of the “lease or buy” decision process. These decisions would be purely based on economic merit, rather than by the expected accounting result.

The changes proposed by FASB will create new temporary differences since assets and liabilities recorded in the financial statements will not be recognized for tax purposes.

Neither FASB nor IASB have committed to an effective date for the new standards, indicating that timing will be based on the comments received and an analysis of the impact of implementation of all new standards in process. Both organizations have indicated they expect to issue a final standard in the second quarter of 2011. Given the transitional implementation proposed in the exposure draft, the standard could be effective in 2011 but may more likely be delayed until reporting periods beginning on or after January 1, 2012. The FASB exposure draft indicates effectiveness based on annual reporting periods, but could be revised to be the first reporting period after that date, i.e., March 31, 2012, for public calendar year entities with quarterly reporting requirements.

BKDis maintaining a thought leadership position on this and other accounting issues and welcomes your questions and insights. Our advisors also may be available to provide summaries or longer detailed presentations on this topic.

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