Lease Accounting Exposure Draft Faces Criticism

October 10, 2013

The Financial Accounting Standards Board and International Accounting Standards Board issued a revised Exposure Draft on May 16, 2013, recommending significant changes to lease accounting. The stated goal of the proposal is to better meet the needs of financial statement users by improving the transparency of lease accounting and increasing comparability between organizations.

The Exposure Draft proposes a dual approach to the recognition, measurement, and presentation of expenses and cash flows from leases. The distinction between capital and operating leases will be eliminated, and replaced with an asset/liabilities approach in which the right to use a specified asset is obtained in exchange for the obligation to pay rent.

Leases of assets that are deemed to consume more than an insignificant portion of the asset (e.g., equipment) will be classified as Type A leases. Lessees will generally recognize the lease as a nonfinancial asset at cost, and separately amortize the asset on a straight line basis and recognize interest expense for the accretion of liability. Lessors will derecognize the carrying amount of the underlying asset, and allocate the amount between a residual asset and the cost of sales for the portion of the underlying asset leased. Lessors will also recognize a lease receivable and profit or loss measured on the lease at the present value of the lease payments to be received during the lease term. The above methods are similar to the current accounting of capital leases.

Leases of assets that do not consume a more than insignificant portion of the asset such as land, buildings, or part of a building will be classified as Type B leases. Lessees will generally recognize a straight-line expense effecting the income statement. Lessors would continue to recognize the underlying asset, and recognize lease payments over the lease term on either a straight-line basis or another systematic basis that better represents the timing in which income is earned from the underlying asset.  This treatment is similar to the current accounting for operating leases.

Because leasing is an important source of financing for many companies, the FASB and IASB argue that financial statement users need to be provided with a complete and understandable picture of a company’s leasing activities. Under current standards financial statement users are forced to estimate the value of the asset leased and liability owed, leading to the potential for an underestimation or overestimation of a company’s leverage.  The FASB and IASB feel that the proposed changes in the revised Exposure Draft will help users obtain a better understanding of a company’s leverage from leasing, and overall improve the quality and comparability of financial reporting information by forcing companies to record the assets obtained and liabilities owed through lease agreements.

The proposed changes will have significant implications for a company’s lease accounting and financial statements as whole. Balance sheets will be inflated with additional assets and liabilities, making a company appear more leveraged. The increase in liabilities will affect a company’s ability to obtain financing and fulfill current debt covenants. Companies will need to consider new capital allocation strategies such as determining whether to lease or purchase an asset and the length of lease terms.

The proposal has received criticism from multiple parties for providing uncertain benefits to financial statement users with increased compliance costs and other possible unintended consequences.

A February 2012 report commissioned by parties such as the U.S. Chamber of Commerce, the Commercial Real Estate Development Association, and the National Association of Realtors argues that the proposed lease accounting changes would distort market behavior and damage both the real estate market and the national economy.  Key findings from the report suggest that under the proposed standard change, liabilities of U.S. publicly traded companies would increase by $1.5 trillion, which would in turn negatively impact both jobs and U.S. GDP.  The report states the negative fiscal impact will result from factors such as reduced spending by companies, higher interest rates on borrowing due to increased liabilities, and reduced commercial real estate values.

The Equipment Leasing and Financing Association (ELFA) has also criticized the proposal arguing that the Exposure Draft is complex and will “unnecessarily increase the cost of lease accounting without significantly improving the quality and relevance of financial statements.” The ELFA has particular concerns with the classification of the majority of equipment leases as Type A leases, which will lead to arrangements being reflected in an equivalent way as the purchase of an asset and separate incurrence of debt.

The FASB’s Investor Advisory Committee (IAC) also declined to support the proposal, instead suggesting that the boards increase disclosure requirements about leases rather than place them on the balance sheet. IAC members argue that the proposed rule changes would require investors and analysts to deconstruct the information placed on the balance sheet prior to performing their own calculations to determine lease liabilities.

The comment period on the revised Exposure Draft closed September 13, 2013. The FASB and IASB hope to finalize the rule changes in 2014, with an expected effective date of 2017.

For more information, contact your Aronson LLC advisor or call 301.231.6200.