Are you ready for potential changes to the lease accounting standards? The U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have jointly developed a new draft standard for lease accounting. Under the current accounting guidance, lessees are required to categorize their leases as operating leases or capital leases. The existing accounting treatment has been criticized for not providing an understandable picture of an entity’s leasing activities by not recording all lease obligations on an entity’s balance sheet.  As a result, the FASB and IASB have proposed new guidance to address this issue.

The proposed lease accounting guidance will impact any entity that enters into leases—not just for real estate. Existing lease arrangements will not be grandfathered, causing all existing leases to be assessed under the new standard. Some of the major changes impacting lessees from the proposal include:

  • All leases will be included on the balance sheet and there will be no distinction between operating and capital leases.
  • A right-of-use asset and a liability to make lease payments will be recognized in the statement of financial position.
  • Initial measurement will be based on the present value of the “likely” lease obligation, discounted using the lessee’s incremental borrowing rate at the lease inception.
  • Interest expense will be recognized on the liability to make lease payments and the right-of-use asset will be amortized over the shorter of its estimated useful life or the lease term.

The described proposed changes could have a significant impact on businesses and users of financial statements. Assets and liabilities would be grossed up due to recognition of all leasing transactions on the balance sheet, which could cause deterioration of key leverage and capital ratios. Lessee’s income statements also will be affected because rent expense will be reclassified as amortization expense and interest expense. Earnings before interest, taxes, depreciation, and amortization (EBITDA) will be more favorable.

Companies could face many operational and strategic challenges adopting the proposed lease accounting changes. Consideration should be given to buying versus leasing certain assets. In addition, gathering and tracking lease data for proper accounting treatment could be a daunting task. Processes and internal controls may need to be revisited.

Due to the significance of this proposal and the potential impact to businesses and users of financial statements, the FASB received nearly 800 comment letters. Currently, the FASB and IASB tentatively decided to revise some key areas in the original proposal to address these concerns. The proposed lease accounting standard will likely take some time for FASB and IASB to finalize. However, significant changes appear to be on the horizon. Companies with substantial leasing activity should begin to prepare for the new rules now. Becoming knowledgeable of the proposal’s requirements will help you transition to the new standard and address the issues impacting your company.

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