The Financial Accounting Standards Board (FASB) has been working for some time to change the method for accounting for leases so the U.S. standards are more in line with the International Accounting Standards Board (IASB).
For government contractors (as well as most businesses that use U.S. accounting standards), the proposed standard could have a detrimental impact. If the rules for accounting for leases change, and the Federal Acquisition Regulations (FAR) do not change or are not amended, current rental costs will be recategorized into depreciation and interest expense.
At the November 19, 2015 FASB meeting, several of the draft items changed. The Board decided to issue a final statement, which is expected in the near future. For nonpublic companies, the new rules are not effective until the first annual reporting period beginning after December 15, 2019; however, they will impact all leases that are effective as of that date.
Operating leases were historically treated as rent expense on a company’s financial statement and the costs were typically fully allowable under the FAR. Under the proposed standards, operating leases will not exist. All leases will be treated similarly as a loan for the right to use a piece of equipment, building, or other asset. Under the new rules, the present value of the lease payments will be capitalized (similar to a capital lease), and the asset will be depreciated over the term of the lease. Since only the present value is capitalized, the difference between the present value and the lease payments will be treated as interest costs. Under the FAR, such interest costs are unallowable but some may be recaptured under ‘Facilities Cost of Capital’ calculations.
The new standard also will increase most companies’ total debt-to-equity ratios, since they will have to recognize the liability in relation to their operating leases. Many banks currently have limits on their borrowers of how high they will allow the total debt-to-equity ratio.
Since there are no changes currently being imposed for federal income tax purposes, operating leases will still be recognized for tax purposes. This means that, subsequent to the change in lease accounting, there will now be an additional reconciling item for tax reporting purposes. There is still a possibility the IRS and some states may adopt the new lease accounting rules for tax purposes, but given how slowly legislation passes and that this topic is not currently being discussed, we do not foresee any changes in the tax rules.
What should companies and government contractors consider doing to prepare for this change?
- If you have to maintain certain debt-to-equity ratios to maintain compliance with your bank or investor covenants, include a paragraph that requires the calculation to be completed under the rules and regulations that existed as of the date of the agreement.
- Management should consider whether they still want to lease equipment, or whether it is now prudent to simply purchase the asset(s).
- Government contractors should consider adding a paragraph in their cost proposals to include a facilities cost of capital calculation.
- Government contractors should contact their professional organizations to put pressure on the FAR to amend their regulations when the changes take effect.
If you have any questions about the proposed rules, please do not hesitate to contact us.
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