Nov 26, 2013

Lease Accounting Standards Update: November 2013

By Don Catalano


lease accountingFor years, the United States' Financial Standards Accounting Board had its own set of rules that differ from the global standards set by the International Standards Accounting Board. However, as globalization continues to define the world's economy, many FASB standards are changing to conform to those set out by the IASB. One significant discrepancy is in how lease accounting works. While the FASB allows companies much more liberal off-balance sheet treatment of their operating leases, that is set to change significantly - PricewaterhouseCoopers has dubbed it "the biggest-ever accounting change."


Capital vs. Operating Lease Accounting

Under a capital lease, a tenant keeps the lease on its balance sheet. The value of the interest gets treated as an asset while the obligation for lease payments gets treated as a liability. Every year, the tenant reports an expense for the part of the lease that would correspond to interest while also claiming a depreciation expense for the reduced interest in the property. Under an operating lease, the company gets to keep the lease off the balance sheet and gets to expense the entire lease payment as it is made. A company that has thousands of operating leases spanning decades can actually call itself debt-free under these rules. Having fewer assets can also improve a company's financial ratios.


Conforming to IASB Lease Accounting

The IASB's standards for operating leases are much less favorable than the FASB's. Starting with the issue of a paper in March 2009, the FASB and IASB have been working together to create a global standard for lease accounting. Under IASB standards, companies with leases have to capitalize them. Relative to the FASB standard, IASB lease accounting makes balance sheets grow while also growing EBITDA since lease payments get treated as interest and depreciation, both of which are excluded from EBITDA.


This change was extremely controversial and, because of the controversy, has led to significant delays in how implementation will happen. Between 2010 and 2013, the FASB and IASB went back and forth with stakeholders trying to figure out a change that would level the playing field for everyone.


It appears that a consensus has formed around requiring that leases be capitalized. Under the consensus, "Type A" leases of equipment would be amortized like current capital leases while "Type B" real estate leases would be expensed on a straight-line basis. With a consensus forming, early 2014 will likely bring the drafting of formal standards to be adopted at the end of 2015 or the start of 2016.


Lease Accounting and You

lease accountingThe change in lease account will impact the own vs. rent decision for many companies. Companies that lease space because it helps them conserve working capital or it helps them to be more flexible in their operations will still be in good position to lease. However, companies that use leased space primarily as a financing tool to help limit the size of their balance sheets or to reduce their debt load might transition from leasing space to buying it. This could have a significant impact on the retail industry.


For most companies, the change in lease accounting makes the own vs. rent decision more complicated. While the real estate equation doesn't change in the near term, the corporate finance one does. The bigger long-term real estate risk could be that an increase in corporate ownership reduces the stock of vacated buildings available for leasing on the re-use market. However, the actual impact of the changes remains to be seen.


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Topics: Lease Accounting

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Don Catalano