The International Accounting Standards Board ("IASB") and the US Financial Accounting Standards Board ("FASB") jointly announced on 19 February 2009 a public consultation on their proposals to change the way leases are reported in financial statements under international financial reporting standards. The proposals would require lessees to report all leases (whether finance or capital leases or operating leases) as assets and liabilities. Such a change would likely have significant balance sheet, compliance and transactional implications for the many companies that rely on leasing as an integral part of their business model.
IASB/FASB public consultation
In a joint press release on 19 March 2009 the IASB, the body responsible for setting International Financial Reporting Standards ("IFRS"), and the FASB, the body responsible for setting US generally accepted accounting principles ("US GAAP"), published their preliminary views on lease accounting in a joint discussion paper, Leases: Preliminary Views, in "response to concerns raised by investors and other users of financial statements regarding the treatment of lease contracts under IFRS and US GAAP".1 The discussion paper notes that existing lease accounting treatment has been criticized for its complexity on the basis that it has proved difficult to define the dividing line between finance and operating leases in a principled way as the current standards require the application of subjective judgments. The discussion paper will be open for public comment until July 17, 2009.
Concerns raised by the discussion paper
The IASB and FASB take the position that the leasing of, for example, a machine, gives the lessee the right to use the machine and creates an obligation to pay rentals regardless of whether the lessee obtains substantially all the risks and rewards of ownership of the machine (this position is often referred to as the "right of use approach"). Yet, under the current rules, many lease contracts presently characterized as operating leases do not appear on lessees’ balance sheets. The IASB and FASB suggest this disparity has created various problems, including:
- investors and analysts having to routinely adjust recognized amounts shown in financial statements to reflect what they see as the true financial position of companies, ie., operating leases giving rise to assets and liabilities;
- economically similar transactions often being accounted for very differently, reducing the transparency and comparability of financial statements; and
- financing transactions being structured to achieve off-balance sheet lease classification that can be difficult for investors to understand.2
Discussion of paper proposals
The IASB and FASB propose that all leases should be reported in a company’s financial statements as giving rise to assets and liabilities in order to create a common standard for lease accounting.
They address in the discussion paper (i) recognition of the assets and liabilities arising in a lease contract, (ii) initial measurement of the assets and liabilities arising in a lease, (iii) subsequent measurement of those assets and liabilities, (iv) accounting for leases with options (e.g. purchase, renewal and termination options), (v) accounting for contingent rentals, (vi) accounting for residual value guarantees and (vii) presentation of leases in financial statements. The IASB and FASB focus on these issues primarily from the perspective of lessee accounting, but also briefly consider lessor accounting.
Having published the discussion paper, the IASB and FASB will next work on an exposure draft of a proposed new standard for lessees, which they aim to have published by 2010. In developing this exposure draft, the boards will take into consideration responses to the discussion paper.
The exposure draft should include timing and methods of implementation, although Grant Thornton, the accountancy firm, has already suggested 2012 or 2013 as the likely years for implementation of the new lessee accounting standards.3 IASB and FASB decided in July 2008 to defer consideration of changes to lessor accounting to a later date, although some relevant issues are described in the discussion paper.
Practical effect of the proposals
Possible practical implications of the proposals, should they be implemented, may include:
- companies that utilize operating leases seeing their balance sheets increasing dramatically - assets and liabilities will increase based on the right of use value and present value of the expected future lease payments, respectively;
- rent expenses under operating leases being accounted for by lessees in a way similar to installment loans, separated into interest expense and repayments, affecting return on assets, debt-to-equity ratios and calculations of leverage (with a potential knock-on effect on, for example, existing loan covenants);
- the increase in assets recorded on balance sheets requiring lessees to hold additional capital;
- added complexity, subjectivity and uncertainty in preparing accounts, arising, for example, from the requirement to estimate likely lease periods and asset and liability components of operating leases at each reporting date;
- added costs in preparing accounts; and
- a change in the approach to future financings and other transactions, both in terms of how leases will be incorporated in the overall transaction structure and how financial covenants within, for example, loan agreements and bond covenants will be negotiated.4
While implementation of any final decision on the proposals with respect to lessee accounting may still be a way off (and even further off for lessors), it would be prudent for businesses to plan ahead on the basis that the current accounting rules may well change, especially where they are negotiating long-term leases or loan facilities with financial covenants that could be impacted by these changes.
Participating in the consultation
Obtaining the discussion paper:
The discussion paper Leases: Preliminary Views is available on the 'Open to Comment' section on the IASB website. Subscribers may also view the document on the IFRSs website. Printed copies (ISBN 978-1907026-02-7) will also be available from:
IASC Foundation Publications Department
30 Cannon Street, London EC4M 6XH, United Kingdom
Tel: + 44 0 20 7332 2730
Fax + 44 0 20 7332 2749
Leases: Preliminary Views is also available here. In addition, any individual or organisation may obtain one copy of the discussion paper from the FASB without charge until July, 17 2009 on written request. Interested parties should ask for FASB Product Code No DP03 and contact:
Financial Accounting Standards Board
401 Merritt 7, PO Box 5116, Norwalk, CT 06856-5116 USA
Phone: + 1 800 748 0659 or + 1 203 847 0700
The IASB and the FASB will each be holding a live web presentation introducing the discussion paper in May 2009. Details on how to register to listen to the web presentation will be announced on the IASB and FASB websites.
Commenting on the discussion paper:
The discussion paper is open for comment until July 17, 2009. Respondents are asked to send their comments electronically to www.iasb.org by registering as a user and then submitting a comment letter via the "Open to Comment" page.
Respondents should note that all responses will be put on the public record unless the respondent requests confidentiality (however, the IASB advises that such requests will not normally be granted unless supported by good reason, such as commercial confidence).
Further advice and information on submitting comments is set out at paragraphs IN26-28 of the discussion paper.