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. In addition, a lack of comparability may result for users of financial statements. As a result, the FASB and IASB have proposed new guidance to address these issues.

The proposed lease accounting guidance will affect any entity that enters into leases and will result in significant changes to the accounting requirements for both lessees and lessors. 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 the following:

  • 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.
  • The initial liability will be measured based on the present value of the “likely” lease obligation, discounted using the lessee’s incremental borrowing rate at the lease inception. The right-of-use asset will be measured at the amount of the liability plus any initial direct costs incurred by the lessee.
  • 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
  • Lessees will reassess the carrying amount of the liability to make lease payments and the right-of-use asset will be evaluated for impairment at the end of each reporting period.

The accounting for lessors is also addressed in the proposed standard. If a lessor retains exposure to significant risks or benefits associated with the underlying asset, the lessor would continue to recognize the underlying asset and, in addition, recognize a right to receive lease payments and a lease liability. If a lessor does not retain exposure to significant risks or benefits associated with the underlying asset, the lessor would remove a portion of the leased asset from the balance sheet that represents the lessee’s right to use the underlying asset during the term of the lease. Lessors will record a right to receive lease payments in the balance sheet, along with a residual asset for the right to the leased asset at the end of the lease term.

The proposed changes described could have significant impacts to businesses and users of financial statements. Assets and liabilities would be grossed up due to recognition of all leasing transactions on the balance sheet. This may cause deterioration of key leverage and capital ratios. Lessees income statements will also be affected because rent expense will be reclassified as amortization expense and interest expense. In addition, expense recognition would be front-end loaded due to the recording of interest expense under the effective interest method. Earnings before interest, taxes, depreciation and amortization (EBITDA) will be more favorable.

Companies could face many operational and strategic challenges in 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.

Because of the significance of this proposal and the potential impact to businesses and users of financial statements, the FASB has received nearly 800 comment letters on the topic. Currently, the FASB and IASB have tentatively decided to revise some key areas in the original proposal to address these concerns. The more significant areas of revision include the classification of leases as “finance leases” or “other-than-finance leases;” determination of the lease term as “reasonably assured,” instead of the proposed “more-likely-than-not threshold;” consideration of variable lease payments in the measurement of a lessee’s liability and a lessor’s lease receivable; issues with the definition of a lease; and further consideration of lessor accounting.

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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