OUR THOUGHTS ON:

Lease Accounting Updates and How They Will Affect Lessees

Transportation & Logistics

By Andrew DiLuciano

If you are leasing or plan to lease your fleets, warehouses or equipment, then you need to monitor the progress of the revised lease accounting standard since it could have significant implications for your company.

In August 2010, Financial Accounting Standards Board (FASB), as part of its convergence process with the International Accounting Standards Board (IASB), issued an exposure draft of an accounting standard that would change lease accounting as we know it. (For details on that exposure draft, see this article written in 2010 - Lease Accounting Changes, Transportation, July 28, 2010.) In response to comments on this original exposure draft, the FASB and IASB met in July 2011 and have announced that they will re-expose a lease accounting standard sometime in the fourth quarter of 2011. They have also announced changes to the original exposure draft that will likely be included in the new draft. This article will attempt to focus on the accounting and operational effects of these changes on lessees. For a summary of the changes that will affect lessors, see this article written in August 2011 - FASB and IASB to Re-expose Proposed Leasing Standard, August 1, 2011.

First, I’ll summarize what the original standard changed for lessees and how they account for leases. No longer will there be two separate classifications of leases (previously, operating and capital). All lease agreements will be included on the balance sheet. Lessees will recognize a “right to use asset” and a “lease liability.” The asset represents the right to use the leased asset, and the liability represents the obligation to make payments on the lease. What used to be rent expense is replaced with interest expense and amortization.

Below is a summary of some of the key changes to the original draft recently announced by the FASB and IASB (collectively, “the boards”):

1. Scope of leases - The boards decided that further analysis is needed to determine if leases for inventory and internal-use software fall within the scope of the proposed guidance.

My Take: If you have lease arrangements for inventory or internally used software, you will want to monitor this, since you could be required to follow this new guidance for these types of leases.

2. Short-term leases – The boards determined that leased assets and liabilities do not have to be recognized for leases with terms of 12 months or less. Rent expense would be recognized over the lease term similar to the current concept of an operating lease. Companies would be required to make this decision based on a class of short-term leases as opposed to on a lease-by-lease basis.

My Take: The boards didn’t really change the definition of short-term leases; they just clarified that companies with short-term leases would not need to follow this new guidance. Their definition of short-term references “the maximum possible term, including any options to renew…of 12 months or less.” This raises questions regarding things like month-to-month leases. Those would most likely not meet the definition of a short-term lease, and would therefore need to be considered in regards to the lease term rules noted below. The new revised standard may clarify how to treat month-to-month leases.

3. Lease term – In determining whether or not to include renewal options in the lease term when determining the lease asset and liability, the boards changed the criteria to a higher threshold. The original draft stated that renewal periods must be included if they were more likely than not to be renewed. Now, companies would include renewal periods if there is a significant economic incentive to renew.

My Take: I think assessing which renewal periods to include in the maximum lease term will represent a significant challenge for companies. The boards have provided some guidance regarding what factors to consider when making the determination if there is a “significant economic incentive to review” and the criteria is similar to current lease accounting guidance. Also, this threshold is higher than the previous more-likely-than-not threshold and may eliminate some renewal periods, but companies are still saddled with the burden of predicting the future and having to make a determination about something that might not occur for several years. This determination will not solely lie with companies’ accounting departments either, since these are organizational decisions we are talking about. These determinations are to be made at lease inception, but many things could change over the term of the lease that could alter the initial determination made regarding economic incentive.

4. Lease modifications – The boards have not yet addressed how to account for lease modifications. They have stated that the revised exposure draft expected near the end of 2011 will include guidance on this.

My Take: I expect this to be similar to debt refinancing guidance. If the lease modification is a substantial change, then the lease would be considered terminated and a new lease would exist. Ultimately, we will have to wait and see what they say in the revised draft. This determination could prove to be difficult if “substantial change” is not clearly defined.

5. Financial statement disclosures – The boards clarified some confusion that arose from splitting what used to be considered rent expense into multiple components. They elected to require a single disclosure that would detail-out lease amortization, interest expense and short-term lease expense. They stated that these amounts must be separated out and could not be combined into one item such as “lease expense.”

My Take: To clarify, the leased asset would be amortized over the life of the lease to reflect the use of the asset. The lease liability is amortized to interest expense using the effective interest method. Requiring disclosure of interest expense could create issues with companies’ debt covenants (this standard in general could do that because it will require putting leases on the balance sheet, which could violate covenants that limit the debt that companies can incur). It will be important to discuss this in advance with all creditors and regulators to make sure they are aware of the effects of this standard and to understand how these changes could impact your company. In addition, this could result in more expense early on in the lease (because of the effective interest method) than under the old lease rules.

Okay – now for the good news: we have time to react and take the proper actions. Once the revised standard is issued later this year, there will be a three or four-month comment period. Expect there to be plenty of comments and push-back on these changes. The boards have not disclosed a potential effective date yet, but given the magnitude of these revisions and the likely amount of comments they will receive, we are probably still a little ways off from this becoming effective. However, we still need to be active throughout this period of time. So make sure you are talking to your executives, boards of directors, accountants, creditors and whomever else you may need to, so you can make the best decisions for your company going forward.

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