Is Lease Accounting Overhaul Finally Reaching Home Stretch?

Jan 21, 2016

Is Lease Accounting Overhaul Finally Reaching Home Stretch?

FASB to Issue New Standard Moving Trillions of Dollars onto Corporate Balance Sheets, Though Rules Won't Take Effect Until 2019
January 20, 2016
After more than a decade of stops and starts, the Financial Accounting Standards Board (FASB) is again scheduled to release changes to financial reporting standards that will require companies to capitalize their real estate and equipment leases, a dramatic shift that potentially could add more than $3 trillion in debt to the balance sheets of U.S. companies.
FASB is expected release the updated lease accounting changes for the U.S. next month after waiting for the London-based International Accounting Standards Board (IASB) to issue its new rules, which were published last week. The two groups have worked jointly since 2006 to try to converge U.S. and international accounting standards in response to concerns from investors, analysts and financial regulators that current standards fails to clearly and transparently reflect lease obligations.
IASB Chairman Hans Hoogervorst said the new requirements will "end the guesswork involved when calculating a company’s often-substantial lease obligations" by bringing "much-needed transparency on companies’ lease assets and liabilities, meaning that off-balance sheet lease financing is no longer lurking in the shadows," Hoogervorst said. “It will also improve comparability between companies that lease and those that borrow to buy."

U.S., Int'l Rules Still Not Identical

Despite the long convergence effort, the two sets of accounting rules will still not be fully converged. The FASB standard to be incorporated into generally accepted accounting principles (GAAP) will be parallel but not identical to the changes issued by the IASB last week.Editor's note: Check out the new IASB lease accounting standard here.
"IASB issued their final standard last week, so this is real," said Jim Dooley, senior vice president of sales and marketing for CoStar Real Estate Manager, which provides software and services for corporate and retail real estate management. "The message to get ready is getting through. In talking with the Big 4 accounting firms and many others, we are all seeing activity increasing exponentially."
While many companies have been preparing for years in many cases, those that have not yet started the transition to the new lease standard face what Dooley describes as an “unknown unknown” -- not fully grasping the magnitude of the task ahead until their financial officers examine the way the changes pertain to their companies.
"From the beginning of the process, there has been little debate about whether operating lease assets and liabilities would be shown on the balance sheet: they will be. So, no matter what form the standard takes, companies will need a complete lease inventory and a comprehensive lease database," Dooley said. "The availability of comprehensive lease information will significantly advance a company’s preparedness."
The IASB standard differs from the FASB proposal primarily with respect to expense and cash flow recognition, according to Moody's Vice President and Senior Accounting Analyst Kevyn Dillow. The U.S. proposal includes two types of leases with different presentations on the income and cash flow statements, each of which produces different expense patterns and different outcomes for certain important credit metrics such as EBITDA, Dillow said.
Such companies may take on billions of dollars in lease obligations as a form of shadow debt under current rules, only disclosed as footnotes in financial statements and not carried on the balance sheet.
The IASB's new International Financial Reporting Standard 16, which goes into effect Jan. 1, 2019, will require lessees to recognize a lease liability reflecting future lease payments and a "right-of-use" asset for virtually all lease contracts, though a lessee may exempt certain short-term and low-value lease assets.

Landlords Exempt But Still Impacted

While landlords are largely exempted from the changes, the IASB's updated guidance and definition of a lease will, at the very least, impact negotiations between lessors and lessees, according to Chad Soares, partner with PwC. Under IFRS 16, any contract contains a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for a consideration.
Both the IASB and FASB changes apply only to tenants, not landlords, and are expected to have the greatest impact on industries that make extensive use of off-balance sheet reporting for leases, such as retailers and restaurants, airlines, travel and leisure companies, and telecommunications and energy firms.
The present average value of retailers’ off-balance-sheet lease obligations is currently over 20% of their total assets, according to an IFRS analysis. However according to IFRS, "some retailers that have gone into reorganization or liquidation show the value of off-balance-sheet leases at almost 66 times the value of on-balance-sheet debt."
Dillow of Moody's said the rating agency routinely make adjustments for off-balance-sheet leases, and the changes will "bring financial reporting closer to our view of operating leases - we adjust reported amounts to add lease debt and a related asset to the balance sheet."
Lease debt is one of the ratings agency's largest analytical adjustments, adding $1.7 trillion, or 8%, to reported debt for global corporations during the last annual period, Dillow noted.
It's too early to tell whether adoption of the changes will lead Moody's to reassess its analytical approach toward operating leases, though Dillow said it currently has no plans to do so.
"Until companies disclose in detail the effect of adopting this standard, the magnitude of these differences will not be clear," Dillow said.
The new lease accounting standards are expected to reduce the number of sale-leaseback transactions because the accounting incentive will disappear. Large corporate users in suburban locations, for example, may now prefer to own versus lease if they have to carry the full cost on their balance sheets.
"Our job is to know that the way we write and design leases affects the tenant in a way beyond the landlord-tenant relationship and that we will need to learn what changes we need to make in our leases going forward," said Ira Meislik, a partner and blogger with New Jersey-based law firm Meislik & Meislik, which specializes retail real estate law and business law.

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