Work is virtually complete on the lease accounting project of the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB).
Both Boards have issued ‘fatal flaws’ drafts of the new standard to selected organizations for final comments. We at the Equipment Leasing and Finance association understand that there are no surprises in the drafts versus what we know from their outlines of decisions made to date posted on their websites. They appear to be on track to sign and issue the new standard by year-end 2015, with a possible effective date of 2018.
The Boards will issue separate standards with major differences in lessee accounting but with lessor accounting substantially converged as they adopted existing GAAP for lessors with few changes. One difference in the versions of lessor accounting is the FASB decided to incorporate concepts from the new revenue recognition standard for determining when a sale takes place in sales-type leases and sale leasebacks, whereas the IASB did not.
The new rules will dramatically change the way leases are accounted for by lessees. The rules will impact the balance sheets of every company, US or IFRS based, that must produce audited financial statements subject to Generally Accepted Accounting Principles (GAAP).
The companies most impacted will be those that lease real estate and large-ticket equipment assets. The list of most impacted companies includes retailers, airlines, rail and truck transportation companies, parcel delivery companies and banks. Virtually every company leases assets, especially real estate which is estimated to be 75−80% of the amounts of operating lease assets and liabilities to be capitalized.
The P&L of US companies will not be impacted, while the P&L and capital of IFRS companies will be negatively impacted due to the front loading of lease costs for the former operating lease under the IASB one lease model.
Regarding lessee accounting the FASB has agreed with the position of many preparers and users including the US leasing industry and the Equipment Leasing and Finance Association (ELFA) on critical recognition and financial reporting matters. They are maintaining a two lease model where some leases are classified as financed purchases of the underlying asset (Type A leases) while other leases are classified as operating leases (Type B leases) when they merely are the acquisition of a temporary right to use an asset for a part of its useful life.
We are hoping the FASB will drop the Type A and Type B designations as they mentioned they would at a recent meeting. In their comment letters to the exposure drafts, independent stakeholders such as the American Institute of Certified Public Accountants (AICPA) and American Accounting Association had both said that lenders and credit analysts need the lease assets and liabilities broken down (finance vs. operating) as a critical component of their decision-making process. They recognize that reflecting the economic substance of the two major classes of leases is important information for users of financial statements.
Type A finance leases will be accounted for as a purchase of an asset and a loan by the lessee just as capital leases are accounted for under existing GAAP. The asset will be amortized over the lease term or, if it is reasonably certain they will exercise a purchase option, the useful life of the underlying asset. Interest will be imputed on the loan using the rate used to measure the liability. Typically, this will be the lessee’s incremental borrowing rate. The lessee rarely knows the implicit rate in a lease as they do not know the residual value. They would know the implicit rate if there was a bargain purchase option in the lease or in a Terminal Rental Adjustment Clause (TRAC) lease or TRAC-like lease where the lessee has a purchase option and residual guarantee set at the same price.
Type B operating leases will be measured using the same present value of lease payments approach as finance leases. The lease expense recognized will be the straight line average rent expense which is a combination of the imputed interest on the lease liability and a ‘plug’ for the amortization of the right of use asset (ROU). It will be displayed on the income statement as a single expense called rent expense.
The ROU assets for Type B operating and Type A finance leases must be reported separately and separate from other property, plant and equipment. The reason is so that users of financial statements understand which assets are owned and which assets are leased. Only owned assets are collateral available to lenders in a bankruptcy liquidation. The Type B operating lease and Type A finance lease liabilities must also be reported separately and separate from other liabilities. The Type B operating lease liability is an ‘other’ liability – not debt – as it does not survive a bankruptcy as a claim competing with other debt for the assets of the bankrupt estate. This change alone will have a hugely beneficial impact as it will avoid unintended consequences such as changes in financial ratios/measures and technical defaults of debt limit covenants in lending agreements.
In contrast, the IASB has decided that all leases create assets and are financings. In their opinion, the assets and liabilities created by all leases are no different than other assets and liabilities. They conclude that since the lessee controls the use of the asset and is obligated to make payments over the lease term it represents a financing of the right to use the asset. That is all true, but the lessee neither owns the physical asset nor is the liability debt in the context of a bankruptcy liquidation. These facts about the legal nature of an operating lease impact the decision to extend credit. A lender needs to understand how it would recover its loan in a worst case liquidation scenario.
The IASB decided on a single-model approach, whereby lessees would account for all leases (other than short-term leases and small value asset leases) as finance leases which feature a front-loaded expense profile due to the combination of the imputed interest component (a declining cost pattern) and straight line asset amortization components of the lease cost. The costs in the income statement will be presented as interest expense and amortization expense. They also combine the presentation of the leased ROU assets and liabilities created by leases, making it impossible for users to know the breakdown. Because the operating lease liability is therefore considered debt, debt covenants will be violated. Because the ROU assets from operating leases are combined with finance lease assets, bank regulators will not have the information to grant capital relief for operating leases as they do now, since operating leases are executory contracts that are voided in bankruptcy.
As for lessor classification, both Boards agreed to retain their respective lessor models. IASB lessors will look to the IAS 17 model for classification while the FASB will retain their FAS 13 model with minor changes. Overall, the decision is viewed as good news because it means lessors can continue to use their current lessor accounting systems.
The FASB decided to conform certain issues to the new Revenue Recognition concept of control to define whether a sale has occurred. As a result, sales type classification is only allowed under the FASB version where the terms of the lease alone transfer control to the lessee. This approach ignores any third party involvement such as a residual guarantee or residual insurance to increase the cash flows considered in the alue test. Third party involvement would still be a consideration in determining if a lease is a finance or operating lease. The difference is if third party involvement is needed to increase the PV to qualify as a finance lease, it is not a sales type lease and the ‘gross profit’ is deferred and amortized as lease/interest revenue. Said another way, the implicit rate used to recognize lease revenue is very high as it considers the asset cost as the investment amount in the implicit rate calculation.
The FASB does provide additional guidance versus the IASB to determine if a sale has taken place in a sale leaseback when a purchase option is included in the lease terms. The FASB allows sale treatment where the purchase option is at fair market value and the asset is not specialized and is readily available in the marketplace.
The FASB and IASB versions differ as to when a lessee must adjust a lease for changes in variable payments due to a change in an index or a rate. The IASB requires lessees to adjust lease accounting when the contractual rents change. The FASB requires recording a change only when an action by the lessee modifies the lease, changes the lease terms, elects an option or does something in its control to change whether it is reasonably certain to exercise an option.
IASB required lessee disclosures are more extensive than under the FASB version.
Lessees with many leases will need to acquire a system to account for their capitalized operating leases. They will need to capture information for all leases existing on the transition date and load the information to produce the necessary comparative statements. In the US, required financial statements for SEC-registered companies means balance sheets for 2017 and 2018 and P&L for 2016, 2017 and 2018. They should begin the project to extract necessary lease data as soon as possible.
Lessees will have to develop a process for accounting for new leases with internal controls. Since operating lease obligations were only reported in the footnotes, existing processes are inadequate. More information will be required regarding the determination of the lease term and lease payments. Lessees will need to evaluate renewal and purchase options to determine if any are reasonably assured of exercise. They will need to determine if any payment is likely under residual guarantees it is providing to lessors. They will need to track variable rents based on an index (like CPI) or a rate (like LIBOR) and possible payments under residual guarantees.
US investment grade lessees will not see much change on the ratios and measures analysts and lenders employ as those analysts are sophisticated and ‘get into the numbers’ in detail. Small and medium-sized companies may have to assist their lenders, which often are smaller banks and finance companies (possibly not as sophisticated as those that deal in the investment grade market) with calculations, especially in treating the operating lease liability as a non-debt liability. Return on Assets and the Quick Ratio will deteriorate but most other ratios and measures are not impacted under the FASB version.
The IASB one lease model will cause most ratios and measures to change for the worse. IFRS companies will see the ratios and measures deteriorate for three reasons – more assets on balance sheet (reduced ROA, Quick Ratio), accelerated costs (reduced ROA) and permanent lost equity (increased Debt to Equity). Strangely, Return on Equity will increase as you have less equity and EBITDA increases as above-the-line rent expense is replaced by below-the-line interest and amortization.
It is likely the market will adjust to the new rules as an accounting change like capitalizing leases should not change the financial strength of a company. In addition, the change in lease accounting will impact all companies. One concern is that there will be more significant changes to the financial statement of those companies that have longer-term leases and/or lease more assets than their peers.
As of September 2015, it appears the Boards will have few public meetings other than to deal with what they call ‘sweep’ issues – small changes discovered in the fatal flaws reviews and feedback. We can read the current project outlines on the Boards’ websites to understand what the final rules will be in general. Lessees especially should be concerned and read the outlines if they have large operating lease portfolios as capturing the data will be a large undertaking.
As mentioned above, a final standard is expected to be completed by year-end 2015. Based on this expectation and the news that the Revenue Recognition standard transition date was moved out to 2018, is seems logical that 2018 will be the Leases project transition date.