New Lease Accounting Rules: IASB and FASB Proposal Debate

Introduction: The Lease Accounting Controversy

The International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) jointly issued exposure drafts on August 17, 2010, proposing a new lease accounting paradigm. The exposure drafts propose changes to simplify lease accounting and improve transparency. The new lease accounting model is based on the core principle that all leases give rise to liabilities for future rental payments and assets that should be reported on the entity's balance sheet. The objective of the new approach is to ensure consistent lease accounting across sectors and to improve the comparability of financial reporting. This paper analyzes the economic impact of the proposed new lease accounting paradigm on the financial statements and derived financial ratios of the reporting entity (Accountancyage.com).

In 2013, the lease accounting world underwent a significant change that gave rise to a controversy still being debated today. The controversy centers on whether to adopt the new system of lease accounting and whether it would be beneficial to companies, firms, business organizations, and the accounting profession as a whole.

Background and the Case for Reform

Prior to the proposed new system, companies and business organizations were able to classify almost all leases and lease agreements as operating leases and were therefore able to exclude them from their balance sheets. This is an established practice that regulators and accounting critics have long criticized. One example that critics frequently cite is the case of airlines: airline companies place all their aircraft on lease but do not disclose these leases on their balance sheets as assets, and consequently do not show the future payment obligations the companies are liable to meet.

There has been widespread pressure to remove this deficiency from the lease accounting system. Showing leases as assets on companies' balance sheets would provide a better understanding of their liabilities and the gains derived from leased assets (Accountancyage.com).

Proponents of the new system argue that improved leasing standards are vital because investors and shareholders are currently forced to make educated guesses about liabilities that are hidden beyond what is revealed in companies' balance sheets.

The new rules, for example, would require an airline that has entered into a lease for a plane to identify and disclose the leased aircraft as an asset on its balance sheet — representing the right to use the plane — alongside an equal liability based on the present value of the lease payments the airline has committed to make to the lessor. This treatment would be analogous to borrowed money, which is already mandatorily disclosed in accounts and balance sheets (Bauman and Francis).

This format of accounting would enable shareholders and investors to know the exact amount the airline owes to other companies and entities, thereby allowing a far better assessment of the total liability associated with the airline's operations. Similar considerations apply to other industries and their investors and shareholders.

This proposal has long been demanded by investors who want companies to show leases as liabilities reflected on their balance sheets.

There are, however, a number of critics of the new lease accounting system. While critics agree that some improvements to lease accounting were necessary, they argue that the transition should be gradual to give companies and business organizations adequate time to adapt. It is expected that the new rules and regulations for lease accounting would be effective from 2017, giving companies time to comply and, in some cases, to renegotiate loan agreements and covenants accordingly.

Under the new system, income statements for many companies would also change, in addition to the balance sheet impact. For example, if a company leased a piece of machinery for $1,000 per year over five years, it would previously show a flat expense of $1,000 each year. Under the new system, the company would report a larger expense in the early years against the leased machinery, with smaller expenses in later years. This is because the new system treats lease expenditures as analogous to a loan taken out to purchase an asset, where interest expense is higher in early periods and declines over time as the principal is repaid (Bauman and Francis).

The treatment of real estate leases would differ somewhat. Even as leases would be placed on the balance sheet as assets, the value of a real estate lease would be based on the expected lease payments over the full lease period. This excludes the consideration of renewal options and associated costs unless it is assumed that renewal would occur at prices favorable enough to represent a significant financial incentive. In cases where lease payments have a variable component — such as a store lease comprising a base rent plus a percentage of sales — the variable element would not be reflected in the initial asset or liability value. This approach helps keep the carrying value of the asset and the related debt lower than would otherwise be the case (Cheng).

Advantages of the New Lease Accounting System

The new system would help in determining the lease term accurately. The longest possible lease term that is more likely than not to occur is defined by the proposed new standard. This assessment also considers the effect of options to extend or terminate the lease and the lease agreement.

Leases may entail several clauses, including unfavorable renewal options, penalties for early termination, and combinations of renewal options and residual value guarantees. These complexities are addressed in the proposed new accounting standards for leases.

A lease contract, for example, may give the lessee the option to renew and continue using the asset, or to return the asset to the owner at the end of the original lease term. In many such contracts, the lessee is required to pay the lessor the difference between the expected residual value and the actual residual value if the lessee decides to return the asset at the end of the contract period.

The new framework allows both the lessee and the lessor to assess at the inception of the lease whether it is more likely than not that the lease will be extended at the end of the contract period. Where leases may be renewed, terminated early, or involve a combination of renewal and residual value guarantees, a probability of occurrence must be estimated for each possible lease term, and a calculation must be made about the expected outcome in order to determine the value of the asset during the lease term and to discount the future lease payments.

The assessment and reassessment of this aspect requires taking into consideration the expected outcome that is more likely than not to occur at each reporting date, where assumptions are based on any new facts or circumstances that may indicate a significant change from earlier assumptions.

The new proposal makes possible the following considerations in assessing the probability for each of the possible lease-end options. Contractual factors taken into account include the level of lease payments, the terms of renewal options, penalties for early termination, and contingent rental payments. Non-contractual factors, such as the influence of local regulations, the costs of relocating the leased asset, and any significant improvements made to the existing leasehold, are also reflected in the new accounting system (Bauman and Francis).

The significance of the underlying asset to the lessee's operations — and whether the asset has a specialized value for the lessee — are business considerations that are taken into account in determining the lease term and reflected in the balance sheet. Other financially relevant aspects, such as the past practices and intentions of the lessee or lessor, are also factored in. This makes the calculation of the actual lease term more accurate and helps investors and shareholders better understand the value of the lease and assess the associated liability (Icaew.com).

Conclusion

While the new rules and regulations do create a certain degree of complexity and would incur some administrative costs for companies and business firms as they prepare their balance sheets, the advantages and the transparency the system would bring tilt it in favor of adoption. The primary beneficiaries would be investors, whose capital funds the companies.

Users of the financial data published by companies would have more information and greater clarity with which to make informed investment decisions, once they are able to see the exact cash flows, the liabilities arising from lease agreements, the precise lease terms, and the associated costs. The new system would also spare users of financial data from seeking out unreliable alternative sources to obtain estimates based on assumptions about lease details and associated risks and benefits.

Regulators would also be better positioned to monitor companies' cash flows and to intervene whenever and wherever necessary.

References

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