Be aware, the way you account for operating leases in your company books is changing. Although, as of now, the issue is in the exposure draft mode, and the FASB (Financial Accounting Standard Board) might soften their views on certain aspects of these changes, the general consensus is that major changes are going to be required when you account for leases in your books.
So, what are these changes and why it’s important to be aware of them? A significant change is that leases accounted for as operating leases that are treated as current operating expenses will have to be booked thru the balance sheet, in other words, capitalized.
The practice of applying payments for a lease agreement directly as a business expense will be eliminated. Instead, you will have to record a liability for and amount that represent the present value of an obligation to make lease payments based on the expected payments. This will require estimates and judgments about uncertain future events (i.e. renewal options and contingencies). Also, as a counterpart, an asset that represents the right to use the particular lease asset will have to be booked.
Sounds like complicated calculations? You might be right, and the problem is that this usually translates to implementation and some other recurring expenditures.
Current GAAP (generally accepted accounting principles) has been in place since the 1970’s and they have been interpreted and amended many times. Many concessions were made to get operating lease treatment for accounting purposes.
The exposure draft issue on August, 2010, proposes significant changes:
- Elimination of the operating lease treatment.
- No grandfathering.
A lease is defined as an agreement conveying the right to use property, plant or equipment usually for a stated period of time in exchange for consideration. For accounting purposes, they can be classified as Capital Leases or Operating Leases:
- Capital leases have to meet any of four specified criteria and are treated as the acquisition of assets and the incurrence of obligations by the lessee.
- If it doesn’t qualify as a capital lease it is an operating lease and it’s treated as a current operating expense.
In the exposure draft, it was proposed that a liability is recorded for the present value of an obligation to make lease payments. The other side of the journal entry will be an asset representing the right to use of say asset. This calculation is based on the expected lease payments to be made over the lease term.
For many leases, the total expense recognized in early years will be higher because the total of depreciation and interest expense will be higher than straight line operating lease expense.
This means that the impact that of these proposed changes will have in of your business are:
- Gross up of assets and liabilities.
- Higher expenses in early years of implementation (accelerated expense recognition).
- Other expenses due to the requirement to reassess estimates and judgments each reporting period (and make any necessary adjustments) and implementation expenses.
- Each and every lease has to be reviewed.
- In the case of banks and other financial institutions, the expense classification impact net interest income.
- For income tax purposes, rent expense is a current deduction.
No specified effective date is available, but the implementation could be a significant undertaking.
What to do to prepare for the changes:
- List all your leases.
- Estimate the possible impact on your financial statements and projections.
- Consider the impact of these changes when entering or negotiating new leases.
- Follow any new developments on the FASB website.
In conclusion, the general consensus is that these changes, probably with amendments and adjustments, are coming and it’s better to be prepared and to quantified any possible impact in your business.