For the past several years, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) have been working jointly towards a controversial new lease accounting approach. Proposed changes have been hotly debated, with the most recent exposure draft released May 16, 2013 requiring all leases with a maximum possible term, including all renewal options, in excess of 12 months to be recorded on an entity’s balance sheet at the present value of lease payments. Over time, the resulting asset would be amortized, and the discount on the lease liability would be unwound. Therefore, despite the fact that incentives are often built into the front end of leases (e.g., initial free-rent periods, escalating rents), the recognized expenses would be front-loaded as well, since the unwinding of the imputed interest in lease liabilities would decline over the life of the lease.
Under the current approach to lease accounting, leases are required to be evaluated at inception and classified as either operating (i.e., off-balance sheet) or capital (i.e., on-balance sheet). The distinction between the two types of leases generally pivots around whether the lease is an in-substance purchase, financed in the form of a lease, and thus should be capitalized in a similar manner as a debt-financed purchase.
If the proposed approach is adopted, nearly all entities will be impacted, but few more dramatically than those that operate in the transportation and logistics industry.
Currently, many transportation and logistics companies rely heavily on operating leases to finance and maintain their fleets and warehouse facilities. The reasons for leasing instead of buying vary, but leasing has become an attractive way to structure transactions, since off-balance sheet leases generally present more attractive financial ratios (e.g., debt-to-equity, return on assets) than a similar company using a debt-financing approach. Also, the accounting for operating leases is usually much simpler, and therefore less expensive. As such, many lessors and lessees structure leases to qualify as operating leases under the current standards.
As a result, the financial statements and key operating metrics used to evaluate a company’s performance and financial health may look dramatically different based on whether a company decides to buy its assets or lease them. The proposed changes may effectively close the reporting gap between companies that lease compared to those that buy, but the adoption of the proposed new standard and ongoing compliance will add significant complexity and expense.
Additional complexity (often as a result of subjectivity) resulting from the proposed standard may include determining: whether a lease will consume more than an insignificant portion of the economic benefits of an asset; how to treat related-party leases with terms that aren’t clearly defined; what to do with lease modifications; whether renewal options have significant economic incentive; which elements of contracts include leases as defined by the proposed standard; restatements of prior periods and loss of consistency with historical metrics.
Further, there may be opportunity for some businesses to restructure certain contracts to avoid, or limit, capitalization under the proposed rules. For example, service contracts are not included in the definition of a lease, and leases with terms of 12 months or less, without renewal options, will not be required to be capitalized. A company may also lessen the impact of the proposed standard on its balance sheet by negotiating shorter lease terms with multiple renewal options that do not contain significant economic incentives.
So what can companies do now while they wait for the final standard? First, commit to staying abreast of future developments related to lease accounting. Next, develop an inventory of all lease agreements and key terms to help minimize the burden of compliance. Also, make note of any debt covenants or contracts based on financial metrics, and consider the impact from the proposed changes. For example, debt-to-equity covenants, as well as compensation agreements, based on EBITDA or other metrics may need to be renegotiated since the calculations could be significantly impacted by the proposed changes.
Have an opinion on how this exposure draft would impact your business? The most recent exposure draft will remain open for comment until September 13, 2013. The FASB did not announce a proposed effective date with the exposure draft.
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