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Lease Accounting Rolling Forward after Two-Years of Spinning Wheels September 12, 2013

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting.

Rip Van WinkelIf you did a Rip Van Winkel and fell asleep a couple years ago listening to the whistle of the lease-accounting-change train as it rolled by … and you just awoke … you’ll be surprised to learn that lease accounting hasn’t yet changed.  You might find that hard to believe; I know I do.  The SEC called for an overhaul of lease accounting back in 2005, and while FASB was slow to react, by 2010 it seemed to be steaming fast towards a new standard.  Here we are now, though, in 2013, and FASB is still soliciting comments on lease accounting.  When all is said and done, it will have taken more than a decade for the inadequacies of current lease accounting to be corrected.

The proposed new standard is, though, still on-track; it never really derailed. Its wheels did spin a lot, though, climbing a mountain of protest over the implications for rent expense accounting and over the administrative burden the accounting creates.  The newest proposal from FASB provides relief on the former, but no relief on the latter.

Status of Proposal

On May 16th, FASB and IASB issued a revised Exposure Draft on Leases.  This was a follow-up to public comment and discussions resulting from the Exposure Draft on Leases issued in August of 2010.  That Exposure Draft, by the way, resulted from public comment on FASB’s Discussion Paper on Leases issued back in March of 2009, which of course, was a response to SEC’s request from 2005.

Comments on the revised Exposure Draft are due September 13th, but it’s hard to imagine any new issues will surface, given all the discussion that has taken place over the years.  Nevertheless, as of this writing, there are about 100 comment letters listed on FASB’s website.

Given the speed, or lack thereof, of the train so far, it’s foolhardy to try to estimate when a standard will arrive, but if a good head of steam gets going, it could be in first half of 2014. Then, while it will be another two or three years before financial statements reflect the new accounting, the required retrospective application to comparative years means that companies will need to establish new processes immediately upon adoption of a new standard.  So, better not take another nap.

 All leases still likely to go on balance sheet

The proposal still has all real estate leases going on balance sheet.  There will be a “right-of-use asset” on the “left side” of the balance sheet and an off-setting lease liability on the “right side”.  While at first blush, it appears that this is a “wash”, if you do the math you’ll see that company balance sheets will appear weaker as ratios such as liabilities-to-assets deteriorate.  For this reason, most companies would have preferred leases not be on balance sheet.  There has, however, been little opposition to the fundamental concept of leases-on-balance-sheets because the logic is too compelling.  For many companies, their single largest class of obligation is leases; without these leases on balance sheet, balance sheets are very misleading.

Difference from current accounting:  Under present accounting, only so-called “capital leases” go on balance sheet; all other leases, called “operating leases”, do not. Most companies have few capital leases.  Only leases that cross the line of one of the following tests are classified as capital leases: (1) the lease conveys ownership to lessee at end of lease or lessee has option to buy property at bargain price at end of lease, (2) term of lease is 75% or more of the life of the asset, or (3) present value of rents is 90% or more of the asset value.  Typically, only very long real estate leases cross these thresholds, and the existence of “bright line” rules have allowed companies to financially engineer borderline cases so those leases stay on the operating-lease side of the line.

Short-term leases:  While a company will be able to elect to not put short-term leases on balance sheet, a short-term lease is defined as one where the term, including options to renew, is 12 months or less.  The option-to-renew qualification means that not many leases would fit this category.

Most real estate leases will be expensed using a straight-line method

The big change FASB has made to its initial proposal for lease accounting is to leave P&L expense accounting for most real estate leases unchanged.  Most real estate leases will be classified as “Type B” leases. (See below for Type A vs Type B classification.)  Expensing for Type B leases will be straight-lined similar to today’s accounting rules for operating leases where, essentially, the rent to be paid over the term is divided by the number of months in the term with the result being the amount of rent to be expensed each month.  This method results in a rent expense that is constant throughout the term of the lease, even if the cash payments themselves are not constant.

Corporate real estate folks can breathe a sigh of relief.  The previous proposal eliminated straight-line rent expense, substituting two types of expenses: (1) a depreciation expense associated with the “right of use” asset and (2) an interest expense associated with the lease liability.   This interest-plus-depreciation expense would have resulted in expenses being higher in the early years of a lease than they would be under straight-line expensing; albeit, they would be lower in the later years.  (This interest-plus-depreciation expense method is, by the way, how capital leases are expensed today.)  This change would have played havoc with corporate real estate budgets, and required corporate real estate folks to have a sophisticated understanding of the intricacies of accounting to explain their budgets to stakeholders.

FASB felt, though, a lot of angst in allowing Type B leases to use straight-line rent expensing.  It’s not a technically pure accounting solution.  FASB has had to introduce new accounting mechanics so the straight-line rent expense can dovetail with the periodic reduction of asset and liability values as the lease term grows shorter.   Working through the issues related to this straight-line expense accounting was one of the major reasons that it has taken so long to finalize a new standard.

Type A vs Type B leases

FASB really wanted to have just one type of lease and one type of lease accounting.  Public comment, though, convinced it to establish two types of leases.  In general, Type A leases would be for equipment and Type B leases would be for real estate. There can be exceptions to each, but that’s the general construct.  Both types would go on balance sheet, but they differ in their P&L accounting.  Type B leases, as discussed above, will have a straight-line expense pattern.  Type A leases will use the front-loaded, interest-plus-depreciation expense method.  The logic is that equipment leases tend to be financing vehicles, in substance, and the interest-plus-depreciation expense method is what would naturally be used if the lease had been legally written as a loan instead of as a lease.

While FASB, who is trying to make a clean break from current accounting, takes great pains to not label Type A leases as “capital leases” (after all, that terminology will go away once new accounting is in place), conceptually that’s pretty much what they are.  There are two key similarities.  First, Type A leases will use the interest-plus-depreciation expense method just as capital leases do today.  And second, the tests that classify a real estate lease as one of those exceptions that need to be treated as a Type A lease are very similar to those that define a lease as a capital lease today.  The main difference is there are no bright lines, in keeping with FASB’s desire to move from rules-based standards (which encourage “style over substance”, sometimes unseemly, financial engineering) to principle-based standards.  In the case of Type A leases, the tests are whether (1) the lessee has a significant economic incentive to exercise an option to purchase the underlying asset, (2) the lease term is for the major part of the remaining economic life of the underlying asset, or (3) the present value of the lease payments accounts for substantially all of the fair value of the underlying asset at the commencement date.  Pretty much the same three tests as for a capital lease; just no bright lines.

In theory, the lack of bright lines will eliminate “style over substance” financial engineering.  Classification of Type A or Type B will be based on the substance of the transaction, not whether certain numerical thresholds have been crossed.  In the absence of bright lines, though, classifying leases will require judgment.  Some people think that, in practice, the industry will use the numeric thresholds in the current capital lease tests, ie 90% and 75%, as benchmarks to inform judgment, even though the numerical values will no longer serve as bright lines.

Administrative Burden

As for the administrative burden of the proposed accounting, it is real, and the revision to the Exposure Draft doesn’t provide any relief.  First, now that leases will appear prominently on the balance sheet, lease data and its reporting will have to meet a much higher standard of timeliness and accuracy than it does in most companies today.  Second, the Type A vs Type B tests will have to be conducted and without bright lines, these tests may be much more difficult to perform than are today’s capital lease tests.  Third, there will be new tests to make sure the right-of-use assets have not been impaired.  Fourth, lease accounting departments will have to track the asset and liability values for each and every lease.  And finally, the new standard calls for much more detailed disclosure of lease information in the notes to the financial statements than has ever existed previously. There likely will be a need for a statistical profile of a company’s lease portfolio so data will have to be recorded so that it can be adequately parsed.

So … the train’s still coming … bringing lots of change, lots of burden.  No time for napping.

Postscript:  Readers who have followed this blog may have noticed that I, myself, took a nap over the last couple years.  There wasn’t much need to post updates on the new lease accounting while the train’s wheels were just spinning.  Now that a new standard may be imminent, I’m back. If you’d like to see future blog posts, make sure to subscribe to receive notices when a new post appears.  You can do so on the sidebar.

As for new readers, check out my older posts on the lease accounting.  With the exception of references on how expense accounting for real estate leases would change to an interest-and-depreciation method (which now is not going to happen), all the other comment and analysis, particularly that related to the implications of the new accounting to corporate real estate executives, is still correct and relevant.  You can find those posts assembled here.


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