BUSINESS INSIGHTS | SPRING 2011 EFFECTAnticipating Lease Accounting Changes? Crunch the Numbers Now
by David Legge
More than 200 years ago, Paul Revere rode by horseback to let us know “the British are coming!” Our world has evolved tremendously since then. Ten years ago, a fax or email might have announced the event. Now it would be a tweet or Facebook posting. If Paul was an accountant and tweeted today, he might be saying “the International Accounting Standards are coming!”
The FASB and the IASB have reached an agreement that starting in late 2012, financial reporting will be done in compliance with International Accounting Standards. Implementation dates are different for public and private companies, as well as for-profit and nonprofit organizations, and will be spread over several years.
Separate from this agreement, a blue ribbon panel delivered a report to FAF in late January 2011 concerning GAAP (public companies) and little GAAP (non-public). The standards overload and constant changing of accounting guidance have made it difficult for multinational corporations to maintain records in compliance with GAAP. However, to properly analyze global companies, it makes sense for everyone to be maintaining their records under the same set of standards and rules.
Since GAAP applies to all entities that provide financial reporting, these requirements also apply to the local community bank and “mom and pop” grocery store. Projects of this nature have been explored before and have taken a long time to implement. It would be easy, therefore, to take the viewpoint that you won’t worry about this until it gets closer to taking effect. But you simply cannot wait.
A major change: lease accounting
There are many differences between U.S. GAAP and the international standards, and the two boards are working to resolve them. One area where the compromise will require a major shift in an accounting treatment in the United States: accounting for lease transactions.
| Abbreviations Key |
| AICPA: American Institute of Certified Public Accountants |
| FAF: Financial Accounting Foundation |
| FASB: Financial Accounting Standards Board |
| GAAP: generally accepted accounting principles |
| IASB: International Accounting Standards Board |
A proposed accounting standards update has already been issued to help resolve the differences in treatment between U.S. and international GAAP in this area. If adopted, it would establish a new accounting model that would significantly alter the way lease accounting is handled by lessees and lessors—most drastically, the elimination of the concept of an operating lease. So why should you be concerned about this change?
Effects on your financial statements
If you look at your audited financial statements, you will see either a separate footnote addressing commitments and contingent liabilities, or a discussion in your “property and equipment” footnote. It includes a breakout for the next five years of your lease payments and the total for the years after. If you own property and are renting it out, you will also have a similar disclosure for the future rental income to be received.
In very simple terms (for what will become a very complex calculation), this number will no longer be a footnote item, but will be recorded on your financial statements. This will result in an increase in total assets and total liabilities. If these numbers are not significant, the result might not have adverse consequences. If, however, you have operating leases that need to be capitalized in the future, we recommend you do some analysis now, so you can plan ahead for negotiating contracts and lending agreements.
Playing with the numbers will help you prepare
By adding these numbers to your current financial statements, you should see what the effect would be on your equity ratios, return on equity, liquidity ratios, return on assets, and fixed assets ratios—just to name a few. You have the opportunity to look at the potential consequence of these changes now and make appropriate decisions for the future (e.g., maybe you only extend the lease for five years instead of ten).
If you are in a regulated industry such as a financial institution, auto dealership, or trucking enterprise, you need to see how these new ratios affect your regulatory compliance. Does it cause you to violate fixed asset regulations or drop you into a different reserve category as your risk ratios have dropped? If you operate in an unregulated industry, you still need to crunch the numbers and look at various contracts or agreements in place. Will it cause you to violate lending covenants, floor plan terms, or partnership or joint-venture agreements? Basically any financial agreement that incorporates ratios or number comparisons as part of the arrangement can be affected.
Planning is always better completed in an anticipated mode than in a reactionary environment; therefore, you should strongly consider analyzing now how this accounting change might impact your organization in the future.