Significant changes have been proposed in the way businesses accounting for the assets and liabilities under leases. The proposals will require a good deal of work and will put many assets under lease onto the lessee’s books.
The exact changes are still being worked through by both the US Financial Accounting Standards Board and the International Accounting Standards Board but both bodies agree that most leases contain a financing component that is not adequately reflected in the lessee’s financial statements.
Why should you care? Because the proposed rules will effect a large number of companies and the rules require prior period restatements.
A few of the significant changes include:
- Leases are to be divided into two types. Type A will include most equipment and vehicle leases and are defined by the consumption by the lessee of more than an insignificant portion of the economic benefits embedded in the underlying asset. Type B will include most real property leases.
- A right-to-use asset and its associated liability will be recorded on the company’s books at the present value of the lease payments. The asset will be amortized over the life of the contract, normally on a straight line basis. Payments on the lease will be split between interest and a reduction of the initial liability on an interest rate basis, just like a loan.
- Contracts covering multiple assets may need to be recorded as separate component leases.
- Contracts that incorporate non-lease components, such as service or maintenance contracts, will need to have the non-lease component accounted for separately.
All of this adds complexity to the accounting but is intended to increase comparability between companies.
Firms that have a number of operating leases on their books should get acquainted with the new rules and make sure that the implications are understood. The rules may unintentionally create covenant problems for borrowers as new long-term debt is added to the borrower’s books, amortization expense increases, interest expense increases and operating profits “improve” as expense shifts from operating expense to interest.