If your business has substantial noncancelable lease obligations, you already need to disclose those commitments in your financial statements – but only in the footnotes. If a new rule proposed by the Financial Accounting Standards Board and the International Accounting Standards Board goes into effect, you’ll need to reflect your commitments for future rent payments on your books as a liability as well as a corresponding asset. The impact could be significant.
This joint project of the FASB and the IASB is intended to add more consistency to financial reporting across a variety of industries and economic sectors. The purpose is to provide more useful and transparent information about leasing transactions in financial statements. But the implications for the reporting companies may be considerable. No, financial standards can’t change how much rent you owe, so there won’t be an impact on your cash flow, but including this asset and liability on your balance sheet will definitely change the appearance of your company’s health; that could affect your performance against loan covenants, or the perceptions of a potential investor.
Imagine you lease office space for 10 years, at $1 million per year. The net present value of that $10 million, using a 5 percent interest rate, is approximately $7.7 million. If this rule goes into effect, you’ll have a $7.7 million liability on your books. Recording that liability will have a dramatic impact on your debt-to-equity ratio, which will certainly catch the attention of any banker.
Typically, lease agreements are either classified as finance (capital) leases or operating leases. A capital (finance) lease is treated very much like the purchase of an asset: the lessee recognizes the leased item as an asset and the obligation to pay as a liability on the balance sheet and depreciates the leased item, apportioning the lease payments between finance charge and reduction of liability. An operating lease is recognized as an expense on a straight-line basis over the lease term.
In analyzing lease contracts, the FASB and IASB concluded that lease contracts (whether finance or operating leases) always create rights and obligations. According to a press release issued on the matter, “The boards propose that lease accounting should be based on the principle that all leases give rise to liabilities for future rental payments and assets (the right to use the leased asset) that should be recognised in an entity’s statement of financial position. This approach is aimed at ensuring that leases are accounted for consistently across sectors and industries.”
The boards issued their joint discussion paper, Leases: Preliminary Views, in March 2009, and opened a comment period which ended July 17, 2009. They received nearly 300 comments, and the opinions have been mixed. About half of the respondents to the discussion paper support the overall principles, noting that the distinction between operating and capital leases is artificial and creates arbitrary complexity. Not surprisingly, the supporters tend to be the users of the financial statements. Yet many who support the principle expressed concern over the difficulty of implementation. Preparers of financial statements and industry organizations tend to oppose the idea, in many cases due to the complexity of compliance.
Despite some negative feedback, it seems likely that this new rule will be enacted, and soon. An Exposure Draft is anticipated in the third quarter of 2010, with roundtable meetings or public forums before the end of 2010. The final accounting standards update is currently anticipated in the second quarter of 2011.
Businesses need to be prepared for the shift, and they need to prepare their bankers. Abel Iglesias, President and CEO at JGB bank, noted, “My team is keeping an eye on this rule as it develops. If it does go into effect next year, lenders need to be aware of the effect on ratios and covenants. Clients with exactly the same financial position may appear much more highly leveraged. In some cases, clients will need to educate their bankers, or better yet, get help from their accountants in providing that education.”
— Tanya Ferreiro, CPA, is an audit principal at Kaufman, Rossin & Co.