By: Jonathan Kraftchick
On September 13, 2013, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) closed out the comment period for the second version of its proposed leasing standards. The latest round totaled over 600 comment letters. Most of the letters, while still somewhat negative, show that many users and preparers alike have resigned themselves to the idea that our balance sheets will soon be welcoming a few new lease assets and liabilities. It seems, though, that the debate has shifted from the balance sheet to the income statement. Once a company has added these new assets and liabilities, what are they supposed to do with them over the leasing term? The Boards have gone back and forth on this issue several times, and based on the 600 comment letters, there is a lot of work to do before this standard is made final.
The proposed literature introduces two types of leases, creatively named Type A and Type B. Type A leases are primarily for equipment, while Type B leases are for property. The Boards may not call these leasing categories ‘Operating’ and ‘Capital,’ but the income statement is treated very similarly to current practice with the exception of a few new twists on the lessee side, which we’ll explore below. The biggest difference between accounting practices for the current lease and the proposed lease is the elimination of the bright-line rule between capital and operating leases. Both Boards have intentionally left out the specific wording or percentages with which we are all familiar. Simply put, management’s judgment will play a much bigger role in determining the distinction between equipment leases and property leases, under the Type A and Type B classification, which could potentially have material differences to the income statement on both the lessee and lessor side.
Below is a chart that describes the new criteria for determining whether a lease is classified as Type A or Type B (identical for lessors and lessees):
- Type A—Leases of assets that are not property (e.g., equipment), unless either of the following conditions exists:
– The lease term is for an insignificant part of the asset’s total economic life.
– The Present Value (PV) of the lease payments is insignificant compared with the asset’s fair value.
- Type B—Lease of property (i.e., land and/or building or an identified portion of a building), unless either of the following conditions exists:
– The lease term is for the major part of the assets’ remaining economic life.
– The PV of the lease payments account for substantially all of the asset’s fair value.
In these definitions, you may have noticed vague terms such as “insignificant,” “major,” and “substantially all”. This is by design. The Boards have refrained from defining any of these terms and are leaving those decisions up to management. This could obviously lead to 2 different companies accounting for an identical lease in two different ways; therein lays the controversy.
Below is how each lease type is accounted for under the proposed standard for lessees. The initial balance sheet treatment is identical for both types. The difference is how the expense and right-to-use asset accretion are calculated.
Since interest expense in the proposed accounting model for Type A would be front-loaded using the interest-method, it could cause early terminations of leases to be more challenging than they are at present. When a Type A lease is terminated early, there could be a gain for the lessee on the balance sheet since the total lease expense (interest and amortization expense) could be more than the cash outlay to date.The impact of this standard is much farther-reaching than just management’s judgment and early termination, however. With different balance sheet and income statement effects, the standard could change compensation agreements, buy/lease decisions, debt covenants, deferred taxes and cash flow categorization without changing the actual substance of the transaction.The release of the new standards is expected sometime in 2014. Regardless of the outcome of any final revisions, the impact of the new standards will have far-reaching impacts on balances sheets, income statements, operational cash flow, debt covenants and other key financial ratios for our clients and the profession.
Jonathan Kraftchick, CPA, is the Senior Manager of Training and Development at Cherry Bekaert, LLP, in their Raleigh office, where he is responsible for overseeing much of the firm’s audit training, course development, and delivery. He attended the University of North Carolina at Chapel Hill and received a BA in economics before continuing on to their master’s of accounting program, graduating in 2001. Since then, he has spent most of his time conducting audit and consulting engagements for a wide variety of companies and industries throughout the Southeast as well as writing and delivering courses both inside and outside the firm. He has also served as a adjunct professor at Elon University in their accounting department. In 2011, he received NCACPA’s Outstanding Seminar Discussion Leader award.