Are you ready for a new lease accounting standard?

(Second of two parts)

By John T. Villa

First Published in Business World (9/2/2013)

In the first part of this article, we looked at the changes that will arise due to the revised Exposure Draft (ED) on lease accounting released by the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) (collectively, “the Boards”). Specifically, we considered how the revised ED will impact on-balance sheet treatment of leases and the areas where significant judgment and estimates will be required. We will now look at the additional data and processes that companies will need to comply with the standard if/when the revised ED is adopted.

Additional data to be gathered and managed

Judgments and estimates

The judgments and estimates required under the revised ED will require in-depth knowledge of accounting personnel, as well as treasury, corporate, real estate business operations, legal, IT and tax. Therefore, a cross-functional project team may be required to gather the data needed to identify and initially record the lease, perform the required reassessments of lease payments and discount rate, and assess the impact of lease modifications.

Transition

With the revised ED providing for the option to apply either a full retrospective approach or a modified retrospective approach to transitioning to the new standard, companies will need to decide which approach is preferable. The approach selected will determine whether companies have to gather historical data as of the beginning of the earliest comparative period presented or as of the commencement date of the lease, which could be earlier. Some companies will also need to evaluate their existing lease processes to determine if the needed information is available, and if it is, whether it is complete and accurate.

IT systems, processes and controls

For many lessees today, lease arrangements are managed through a variety of spreadsheets or software programs that may not be sufficient to handle the proposed accounting requirements. Companies would need to understand whether existing systems can be modified or if new systems will be required to meet the new accounting, financial statement presentation, and disclosure requirements. As part of implementing any IT system, it is important to develop processes and controls for maintaining documentation of management’s judgments and estimates. Furthermore, companies may need to keep and track differences in treatment for tax reporting purposes. This would increase IT system requirements, and may further complicate processes and controls.

Identifying, developing and implementing changes to IT systems are not easy, and the amount of time necessary will depend on the legacy systems. Companies that are currently designing or upgrading IT financial reporting systems should consider the revised ED as part of their current IT development efforts. This could reduce the risk of costly rework later. Companies should also be mindful that although IT programs can help accumulate data and perform calculations, no program can make the critical estimates or judgments required by the revised ED.

Financial statements and metrics

Lessees

For many lessees, the grossing-up of the balance sheet could cause deterioration in debt ratios and return on assets compared with current accounting. Certain regulatory ratios may also be impacted. Because the timing of expense recognition generally would accelerate, and rent expense would be re-characterized as interest and amortization expense for Type A leases, financial metrics such as Earnings Before Interest, Taxes, Depreciation and Amortization and interest coverage ratios would be affected.

Lessors

For lessors with leases that are classified as operating leases today but will be classified as Type A leases, the revenue recognition pattern would change. Rather than rent income and depreciation expense, which are generally recognized on a straight-line basis, companies would recognize an upfront profit or loss and interest income, which generally would be accelerated over the lease term. On the balance sheet, the underlying leased asset would be derecognized, and a lease receivable and residual asset would be recognized.

Even for lessors that currently apply finance lease accounting, the implicit rate in the lease would increase because of the recognition of a residual asset, resulting in a lower amount of finance lease receivable initially recognized. This, however, will result in higher interest income that will be recognized over the lease term following the effective interest method of accounting.

Companies should assess the potential impact on their financial statements and metrics, and evaluate how the revised ED could affect the way stakeholders view their financial performance. Some companies may need to communicate the key performance indicators to their stakeholders under both current lease accounting and accounting under the final standard during the transition period.
In addition, companies should identify whether existing compensation and debt arrangements would need to be changed, which may not be simple. For instance, companies may need to negotiate with their creditors either to allow for more headroom in covenants, or to allow for the continued use of current lease accounting in the covenant calculations.

Tax considerations

The revised ED will also affect taxes. These effects include understanding the impact of the lease accounting changes on existing tax positions, initial adjustments to deferred taxes, and tracking book/tax differences. The complexity of the revised ED may also confuse users, and possibly expose companies should tax authorities start assessing taxes based on the application of the revised ED. Tax authorities might find it harder to reconcile how lease contracts are accounted for in the financial statements compared to how they are reported for tax purposes, and this can trigger more questions and assessments. Companies would need to assess the necessary changes to tax-related processes and controls required to identify, quantify and track tax adjustments, and monitor book-tax reconciling items.

Lease or buy?

Companies should understand the potential impact of the revised ED and related financial metrics as they negotiate for new leases.
Lessors engaged in the leasing business should understand how the revised ED may affect their customers’ behavior. For example, certain lessees may desire shorter lease terms or a higher proportion of variable rents to minimize the financial statement impact. However, such terms could result in unpredictable revenue for lessors. As a result, lessors may seek to be compensated by increasing lease payments or reducing lease incentives.

Furthermore, because the proposed lease accounting model differs significantly from current accounting, notwithstanding the costs required to implement the proposals, some lessees may consider buying assets instead of leasing them. Lessors also may consider modifying their offerings in such a way that they do not contain lease components under the revised lease definition. At a minimum, companies entering into new leases should at least be aware of the potential impact of the revised ED. While companies should not make business decisions based primarily on accounting results, they should be aware of the accounting consequences of their decisions.

Next steps?

As currently proposed, an accounting change of this magnitude could present a daunting challenge for many companies. Therefore, an early understanding of how the proposal would impact each company is critical. All companies with significant leasing activities should review the revised ED, consider submitting a comment letter before September 13, 2013, and closely monitor the Boards’ re-deliberations. As in any accounting issue like this one, starting early is the best way to reduce the overall adoption and implementation cost, and to avoid unwanted surprises and costly missteps. Finally, there is always an option either to just wait for the new standard to be finalized and accept it, or raise the noted concerns and provide meaningful commentary while there is still an opportunity to do so.

John T. Villa is a Partner of SGV & Co.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.