by Chris Frye, CPA
It has been a long seven years since the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) took on the daunting task of revising the accounting standards for lease transactions. After substantial public outcry in response to its first two exposure drafts, the joint task force has since issued what it hopes are near final regulations in regard to the accounting changes. The third exposure draft was released on May 16, 2013.
The original mission of the joint effort was to more accurately portray an entity’s future obligation as it relates to lease arrangements. Under current accounting standards, leases are classified as either operating or capital leases based on the presence or absence of certain key provisions. Capital leases, which closely resemble a financing or purchasing of an asset, are recorded as an asset and liability on the balance sheet, while an operating lease impacts only the income statement as the corresponding rent payments are made. The current accounting model has inadvertently led to the structuring of lease transactions to avoid meeting the predetermined capital lease criterion. Under the proposed accounting model, all non-cancellable leases greater than 12 months (including renewal options when there is an economic incentive to extend) will be required to be recorded on the balance sheet as a “right-of-use asset” and a “lease liability.”
The new exposure draft proposes treating most real estate leases as a straight-line amortization of the right of use asset and lease liability on the entity’s income statement. Leases for equipment and similar assets would include amortization of the right of use asset in addition to an interest component on the lease liability. The recording of a right-of-use asset and lease liability will significantly change the presentation of the balance sheet for most organizations. The addition of the lease liability, which may be substantial for entities with high-dollar and long-term leases, has the potential to negatively impact debt-to-equity ratios. This could have significant implications on debt covenants that are inherently tied to these ratios.
Those who will be significantly impacted by the proposed changes are encouraged to provide comments on the exposure draft by September 13, 2013. Please contact your Yount, Hyde & Barbour service team for more information on the revised regulations and how they could potentially impact your organization.