Companies Should Prepare for New Accounting Standards Affecting Leases

A proposed overhaul of the current lease accounting standards by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) will significantly affect many companies’ financial statements and other aspects of their business. While waiting for a final standard, companies can take steps now to begin to assess the implications around financial statements, data requirements, technology, and process changes.

Under existing standards, leases of equipment and other assets that meet certain criteria are generally classified as “operating leases,” and do not appear on the balance sheet. The proposed new standard, which was released for comments as an exposure draft on May 16, 2013, would require lessees to include all leases that extend for more than one year on their balance sheet. The new rules would also apply to existing leases, since no “grandfathering” exemptions are currently being considered.

In the latest exposure draft, FASB and IASB maintained (and will not likely change) their position that all assets acquired under long-term lease agreements are to be recorded on the balance sheet as “right-to-use” assets, with a corresponding “lease liability” recorded. Therefore, companies that use a significant amount of leasing should examine how their financing strategies and expense recognition would be affected if the proposed standard is implemented.

Government contractors

Contractors doing business with the government are subject to the provisions of the Federal Acquisition Regulation (FAR) and, therefore, may find their contracts affected by the proposed standard. A primary underlying principle of the FAR is the requirement that contractors report their results in conformity with generally accepted accounting principles (GAAP). The new standard will most likely not impact all financial metrics, but working capital and debt-to-equity ratios and a company’s overhead rates may be negatively impacted for both equipment and real estate leases.

The following tables demonstrate the expected impact on a company’s income statement and balance sheet for a seven-year equipment lease, with a monthly payment of $7,500 and an interest rate of 5.25 percent.

Income statement

Current Standard		Proposed Standard
	Rent expense	Amortization expense	Interest expense	Total
Year 1	$90,000.00	$75,248.26	$25,621.36	$100,869.62
Year 2	$90,000.00	$75,248.26	$22,669.03	$97,917.29
Year 3	$90,000.00	$75,248.27	$19,047.85	$94,296.12
Year 4	$90,000.00	$75,248.26	$15,231.89	$90,480.15
Year 5	$90,000.00	$75,248.27	$11,210.73	$86,459.00
Year 6	$90,000.00	$75,248.26	$6,973.30	$82,221.56
Year 7	$90,000.00	$75,248.27	$2,507.99	$77,756.26
TOTAL	$630,000.00	$526,737.85	$103,262.15	$630,000.00

Balance sheet

Proposed Standard
	Right-to-use asset	Lease liability	Working capital
Lease inception	$526,737.85	$526,737.85	$(64,378.64)
End of year 1	$451,489.59	$462,359.21	$(67,330.97)
End of year 2	$376,241.33	$395,028.24	$(70,952.15)
End of year 3	$300,993.06	$324,076.09	$(74,768.11)
End of year 4	$225,744.80	$249,307.98	$(78,789.27)
End of year 5	$150,496.53	$170,518.71	$(83,026.70)
End of year 6	$75,248.27	$87,492.01	$(87,492.01)
End of year 7	$ -	$ -	$ -

Under current FAR cost principles, rent expense is typically considered an allocable and allowable cost. Interest expense is not, and therefore contractors should consider how their interest expense will be affected by the proposed standard.

Real estate

Generally real estate leases will be classified as Type B leases and will be accounted for under a single-expense recognition method — rent expense versus amortization and interest. Therefore those leases’ impact on allowable costs under the FAR are not likely to be affected the same way as equipment leases. However, the impact on the balance sheet and working capital will be similar to the example above.

Bonding capacity

Although the total cash outflow and overall expense of a lease remains the same, there is a significant effect on the annual totals in the income statement and on the working capital in the balance sheet. If a construction company has several large equipment leases, the impact on working capital and bonding capacity could be detrimental to its operations.

Equipment leases will be a large issue for many construction companies, but the effect on their balance sheets will generally be lower than real estate leases.

Implementation

While the new standard will not likely be implemented until 2015 or 2016, companies should start assessing how it will impact on their finances now.

A company that has a large number of smaller leases (e.g., computers, copiers, postage machines, and other office equipment) will find that the additional effort and resources required to track, evaluate, and monitor their lease portfolio will need to increase — in some cases substantially. The cost of purchasing and implementing the technology to handle this requirement may not be cost effective, and companies may need to develop internal processes to address these new requirements. For instance, they should gather their information maintained for all leases that exceed one year in length, including:

• Lease commencement and expiration dates
• Option terms and dates
• Rent, including any increases
• Security deposits

Assumptions used to value the leases will need to be monitored and reassessed at least annually. Going forward, companies will need to closely evaluate their decision processes to buy or lease equipment.

The proposed standard may also create tax consequences for companies with their property taxes and franchise taxes.

Due to the complex nature of the new standards, companies should consider seeking assistance from an advisor in evaluating the financial and tax impacts of the new rules.