Getting into the “nuts-n-bolts” of lease accounting might be venturing a little “into-the-weeds” for some; however, for any businessperson that deals with finances or is interested in knowing how debt service is actually covered by cash flow, lease accounting should be an important issue.
Historically, leases have been broken into two categories: “Operating Leases”, or those where the asset is basically rented, and “Capital Leases”, those where the asset is actually being purchased, or rent-to-own. Capital Leases, as the term implies, have always been capitalized, with the asset and the obligation shown on the Balance Sheet. Operating Leases, on the other hand, the ones which are basically “renting” an asset are a different matter. To date, Operating Leases are “expensed” through the Profit & Loss or Income Statement, with the totality of the obligation only to be found in the Notes to Financial Statements. Back in May, I wrote in a blog post concerning a proposal between the Financial Accounting Standards Board and the International Accounting Standards Board (the Boards), respectively the U.S. and international entities in control of acocunting standards, recommending a change in Lease Accounting, bringing all leases onto the Balance Sheet as opposed to the current situation where the obligation or liability of operating or “renting” leases are only being dealt with in the Notes to Financial Statements. The Boards left the recommendations opened for comment until September 13, 2013.
According to Ken Tysiac in an article in the Journal of Accountancy dated September 23, 2013, titled “Type A or Type B? Lease concerns emerge at round table“, the Boards proposed a standard for lessees in leases that last longer than one year, breaking leases into two categories, based on consumption:
According to Tysiac, “Type A lessees would recognize a right-of-use asset and lease liability, initially measured at the present value of the lease payments, and recognize the unwinding of the discount on the lease liability as interest separately from the amortization of the right-of-use asset”. “Type B lessees would recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments, and would recognize a single lease cost on a straight-line basis, combining the unwinding of the discount on the lease liability with the amortization of the right-of-use asset”.
As Tyasic notes in his article, there were many concerns with these proposals:
Overall, the round-table comments reflected the complexity associated with the Boards attempts to create one model for a transaction with so many variations.
In another article by Ken Tyasic in the Journal of Accountancy dated October 15, 2013, titled “AICPA committee calls for diferent dividing line on leases“, he states the “the AICPA Financial Reporting Executive Committee (FinREC) supported the proposal’s dual-mode approach for lessee and lessor accounting” but “disagreed with the proposed tests that would determine whether a lease is classified as a Type A or Type B lease”. FinREC Chairman Richard Paul, CPA, said that “we think the cut could be simpler and based on the economics of the lease”, recommending that “leases consistent with in-substance finance purchases be accounted for as Type A leases and that other leases be accounted for as Type B”. This recommendation would be more in line with current Generally Accepted Accounting Principles (GAAP) where leases “to own”, or those with a minimal “buy-out” at the end of the lease are acocunted for as Capital Leases and leases where the asset is returned to the lessor or has a substantial “buy-out” to own at the end of the lease are accounted for as Operating Leases, with the most significant difference being ALL leases would now be capitalized, with a liability and asset being booked and written off over the term of the obligation.
FinREC acknowledged some of the concerns expressed in the open comment period, saying “the classification test should be based on clearly articulated principles and field-tested to insure that it is operational”, but also suggested that “the Boards give robust consideration to costs and benefits as they formulate final standards”. With those comments, FinREC encouraged the Boards “to continue working toward a converged standard in a project that is diffcult because of the variety of leases that exist”. Tysiac quoted Richard Paul as also saying: “When you’re dealing with something as pervasive, that crosses as many industries as leases, it’s really important to get to a converged solution because comparability is the objetive when you’re talking about convergence”, and “it certainly would be beneficial when comparing entities domestically and internationally with something as fundemental as leases”.
This brings me right back to my blog post in May, where I stated that bringing all lease obligations onto the Balance Sheet is of utmost importance. As I said in May, once a lease is signed, it is an obligation, a Liability of the entity signing the lease and should be acocunted for as such, as opposed to being buried in the Notes to Financial Statements. It appears most parties agree that all leases should be accounted for as liabilities, with the particulars as to how this will materialize still to be worked out.