Audit, Compliance and Risk Blog

Lease Accounting - Will There be a New Accounting Standard?

Posted by Ron Pippin on Thu, May 10, 2012

Ron PippinThe current rules for lease accounting in the United States go back to 1976 and have been interpreted, modified, amended, and revised numerous times over the years. The existing U.S. accounting standard is complex and, some say, arbitrary because it allows companies to structure transactions to meet the rules of the standard, and helps keep significant liabilities off their balance sheet.

For example, the airline industry (e.g., United Continental Holdings, Inc.) leases many of its aircraft by signing lease contracts with either the airline manufacturer or a third-party finance company. If properly structured, the annual cost of this arrangement will be shown as a normal operating expense by an airline company, which avoids showing the aircraft (asset or liability) on the airline’s balance sheet. The details of the leasing arrangement are required to be disclosed in a company’s financial statement footnotes as an “off-balance-sheet commitment.”

In August 2010, the Financial Accounting Standards Board (FASB), which establishes generally accepted accounting principles (GAAP) in the United States, together with the International Accounting Standards Board (IASB), which establishes accounting rules (International Financial Reporting Standards or IFRS) for Canada and many other countries around the world, issued a combined exposure draft that if finalized, would significantly change the way in which companies account for their leases—whether as a lessor or lessee.

Originally, these two boards were hoping to finalize the guidance for lease accounting in their joint proposal sometime before June 30, 2011, a date to match the end of the term of the then-current chairman of the IASB, Sir David Tweedie. For several reasons, this did not happen.

Now, nearly one year later, the two boards have decided to “re-expose” a reworked exposure draft sometime in the second half of 2012. This decision was deemed necessary because the boards have made several changes to their August 2010 exposure draft. This means the boards will have to again solicit feedback on the updated exposure draft, consider such feedback, and then presumably issue final standards; probably late in 2013 or possibly 2014. The time frame for adoption and implementation of the new lease accounting rules is anyone’s guess as the boards still have much work to do before they can issue a revised exposure draft and finalize the rules.

As a result of constituent feedback, the boards have “softened” the proposed accounting in the exposure draft for short-term leases and the way renewal periods and contingent rentals should be considered, whether by a lessor or lessee.

The boards have made other changes to the lease accounting proposal, but the real controversy has not been resolved which could result in the project falling apart or dragging on for some time to come.

While there is general consensus that lessees of assets such as airplanes used by airline companies should include those assets on their balance sheets (with a corresponding liability to repay the lessor), there is no such consensus on how the assets and liabilities should be removed from the balance sheet, and related charges against earnings.

Let’s consider a simple example. A company has a 10-year noncancelable lease that requires payments of $100,000 per month or $1,200,000 per year or $12,000,000 over the entire lease term. Under existing U.S. GAAP (similar in most respects to IFRS reporting) the lessee would likely conclude that this lease meets the criteria for being an operating lease, and would record a lease expense of $1,200,000 for each year during the 10-year term, and make various disclosures in its financial statement footnotes. As proposed in the exposure draft, the lessee would be required to initially record the right-of-use asset and liability associated with the leased asset at its present value.

Assuming a discount rate of 8% and disregarding initial lease costs, the lessee would initially record this asset and related liability at $8,242,000. Thereafter, the lessee would charge two items to operations—amortization expense on the “right-of-use asset” and interest expense on the lease liability. Assuming the lessee has an accounting policy that follows the commonly used straight-line method of depreciating its assets, in this simple example, the related amortization expense would be $824,200 per year. And, in the first year of the lease, interest expense would be $640,000 and together with the amortization expense, the lessee would charge its operations $1,464,200 or $264,200 more than under current accounting rules. The accounting “gets better” in later years; for example, in year 10 of the lease, interest expense would only be $50,000. In short, many lessees are not happy with this “accelerated approach” to recording expense, and the FASB and IASB are looking for supportable ways to make the difference “go away.”

Financial Executives International (FEI), an influential association of key financial executives, made the following observation in a recent comment letter to the boards regarding this issue:

"FEI notes that there are alternative treatments available to the Boards that avoid these consequential effects and are more theoretically supportable, from both economic and technical perspectives. The annuity method of depreciation is one such alternative."

Some accountants would find the annuity method of depreciation without any merit, but it would substantially make a lessee’s income statement more closely match the result under existing lease accounting rules. Some members of the IASB and FASB seem to be somewhat supportive of this change, but as a whole, the IASB appears to be more sympathetic than the FASB to the concept of reducing the impact on earnings of lessees, whether by this “annuity method” of amortizing or depreciating leased assets or possibly by other methodologies including how interest expense on the lease obligation might be recognized.

Companies that are lessees with numerous leases have complained loud and clear to the boards. Separately, both lessors and lessees have complained about the extensive bookkeeping associated with the proposed accounting in the exposure draft that will require companies to enhance their data tracking systems.

Whether the boards can agree to a final standard that companies and investors alike will be supportive of remains to be seen.

About the Author

Ron Pippin is an experienced CPA based in Wheaton, IL. His 40 plus year career includes being an audit partner in Arthur Andersen, a member of Andersen’s Professional Standards Group (“national office”) in Chicago, the Director of Financial Reporting for a Fortune 50 company and most recently, the editorial director of CCH’s Accounting Research Manager. Currently, Ron does independent writing and analysis together with accounting consultation on a variety of topics.

Tags: Corporate Governance, Business & Legal, Accounting & Tax, Lease Accounting, US GAAP