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D espite the extensive rules that govern lease accounting, finan- cial statement users often criticize the “bright-line” rules in existing standards for differentiating capital leases from oper- ating leases. The primary criticism stems from the fact that

current standards allow companies to structure leases to suit their financial reporting preferences; thus, companies frequently engage in complicated arrangements involving third-party guarantors in order to avoid reporting lease agreements as capital leases (i.e., to avoid

recognizing the asset and the related liability in their financial state- ments). These rules permit companies to develop to leasing arrange- ments that cover multiple years with no balance-sheet recognition; thus companies widely utilize leases as a mechanism for off–bal- ance sheet financing. In addition, comparability suffers because com- panies use varying accounting treatments for economically similar lease transactions.

To address these concerns, FASB and the IASB have joined forces

Proposed Changes to Lease Accounting under FASB’s Exposure Draft

A C C O U N T I N G & A U D I T I N G a c c o u n t i n g

JUNE 2013 / THE CPA JOURNAL28

By Mark E. Riley and Rebecca Toppe Shortridge

Implications and Preparatory Steps for Lessees

to develop a comprehensive exposure draft, Proposed Accounting Standards Update (Revised), issued May 16, 2013, regarding Accounting Standards Codification (ASC) Topic 840, “Leases.” If implemented, the exposure draft will replace ASC Topic 840; the comment period for the revised expo- sure draft ends September 13, 2013. If enacted, this standard would substantially reduce the opportunities for companies to use leases as off–balance sheet financing. (See Exhibit 1 for an illustration comparing the proposed standard and the current stan- dards, as well as the goals of the exposure draft.)

The ensuing discussion explores the content of the revised draft, as well as the financial reporting implications for lessees, including transition rules and the steps that CPAs can take in planning for a potential new lease accounting standard. In consider- ing possible financial reporting implications, two examples of companies that make exten- sive use of operating leases under current standards are presented. These examples illus- trate the nature of the changes that a new leasing standard could have on companies’ balance sheets.

CPAs can start preparing for this pro- posed standard by familiarizing themselves with its provisions and by preparing for compliance with the new standard. Although the new exposure draft recom- mends significant changes to both lessee and lessor accounting, this article focuses on lessees.

Revised Exposure Draft The overriding theory behind the expo-

sure draft is that when a lessee enters a lease with a term of one year or greater, the lessee acquires a right-of-use asset and incurs a contractual obligation. Under existing stan- dards, many leases that extend for multiple years are treated as operating leases, which results in an operating expense on the lessee’s income statement and no recogni- tion of an asset or obligation on the lessee’s balance sheet. The proposed stan- dard only permits leases with a possible maximum term of one year to be treated similarly to operating leases (i.e., not rec- ognized on the balance sheet).

The exposure draft defines a lease as “a contract in which the right to use a spec- ified asset (the underlying asset) is con- veyed, for a period of time, in exchange

for consideration.” The exposure draft requires lessees to recognize the exclusive right to use an asset and the related com- mitment to pay for that right. Exhibit 2 pro- vides a series of questions that CPAs should ask when considering whether a contract meets the exposure draft’s defini- tion of a lease. It is important to note that leases covering intangible or biological assets and exploration for minerals, oil, nat- ural gas, or similar resources are exempt from the exposure draft.

Recognition of asset and liability at lease commencement. Under the new exposure draft, a lessee will calculate the amount of the initial asset and liability as the present value of the future lease pay- ments. The discount rate used in comput- ing the present value of lease payments will be determined based upon the interest rate charged by the lessor, if that rate can be ascertained. If the rate charged by the lessor cannot be determined, the lessee will use its incremental borrowing rate to

29JUNE 2013 / THE CPA JOURNAL

EXHIBIT 1 Comparison of Current and Proposed Standards

All leases greater than one year are treated as capital leases.

Many leases remain off–balance sheet.

Pr op

os ed

S ta

nd ar

ds

Current Standards

Goals: 1. Similar leases treated consistently 2. Reduce off–balance sheet financing

Control and Benefit n Can the lease control the asset? n Does the lessee receive the benefits from the use of the asset? Specified Asset n Is the asset identified in the contract? n Is the asset physically distinct or a physically distinct portion of a larger asset? (Note that a capacity portion of a larger asset does not qualify as physically distinct.)

EXHIBIT 2 Is the Contract a Lease?

Determine if Calculate present Recognition lease exists value of lease requirements

n Right to use a specified n Use lessor’s discount rate n Asset (including asset? if known initial costs)

n Right is for more than n Otherwise, use lessee’s n Related liability one year? incremental borrowing rate

EXHIBIT 3 Initial Lessee Tasks

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JUNE 2013 / THE CPA JOURNAL30

compute the lease payments’ present value. To ease implementation, nonpublic entities are permitted to use a risk-free discount rate that must be disclosed in the notes.

Thus, leases that were previously recorded as operating leases (i.e., without balance sheet recognition) will be recog- nized on the balance sheet in a manner sim- ilar to the current recognition of capital leas- es. It is possible that a lessee will record the right-of-use asset and lease liability at different amounts because initial direct costs incurred by the lessee will be added to the initial amount at which the asset is record- ed. Exhibit 3 shows the initial tasks a lessee might perform when accounting for a lease under the new standard.

An example can be useful in illustrat- ing the basic differences in recognition under current standards and the exposure draft. Assume that on January 1, 2014, Blue Inc. enters into a contract to rent equipment for a five-year period, with annual $1,000 payments due on January 1; also assume that Blue knows the lessor’s discount rate is 6%. The economic life of the equipment is eight years, and its fair value is $7,000; because this contractual agreement involves a specified asset (the equipment) and extends for more than one year, it will be treated as a lease, with the fair value of the underlying asset and related commitment recognized on the bal- ance sheet as an asset and a liability at the present value of the payments ($4,465). An amortization schedule for this lease agreement is provided in Exhibit 4. Under the current standards, it is likely that Blue would not recognize an asset or liability at the commencement of the lease because it does not meet the capital lease criteria specified under ASC Topic 840.

Recognition of lease expense. The new exposure draft directs lessees to follow one of two expense recognition patterns: the interest and amortization approach for type A leases or the straight-line approach for type B leases. The exposure draft indi- cates that the lessee’s expense recognition pattern will depend largely upon whether the lessee is expected to consume more than an insignificant portion of the underlying asset’s economic benefits. Furthermore, the assessment of whether this is the case will generally depend upon the nature of the underlying asset.

The revised exposure draft distinguishes between leases of property (i.e., land, build- ings, or part of a building) and leases of assets other than property (i.e., equipment). Leases of assets other than property are typ- ically type A leases; these leases usually comprise a significant amount of the asset’s ecnomic life and are accounted for using the interest and amortization method. Leases of property are typically type B leases; lessees are directed to use the straight-line expense approach for these leases.

The straight-line approach, as the name suggests, results in equal rental expense (the total of interest on the lease liability, plus amortization of the right-of-use asset) every year. Under this approach, a lessee recog- nizes interest on the lease obligation at the appropriate discount rate and recognizes amortization in an amount equal to the dif- ference between total (straight-line) expense and the amount of interest. The total amount is reported as lease expense on the income statement. The interest and amorti- zation approach generates an annual expense that is equivalent to the expense recognized when an asset is purchased using a loan and then depreciated annually. The interest

expense and amortization expense are report- ed separately on the income statement. Under this approach, total lease-related expenses will tend to be higher in the earlier years of the lease than in later years.

Based on the previous example of Blue, it is likely that the equipment lease would be categorized as a type A lease; therefore, Blue would recognize lease expense using the interest and amortization approach. For comparative purposes, Exhibit 5 summa- rizes the financial statement effects for Blue after one year of accounting for its equip- ment lease under the current standards, the proposed straight-line approach, and the proposed interest and amortization approach. Under both the current standards and the straight-line approach, Blue rec- ognizes a total lease-related expense of $1,000 in the lease’s first year. Under the interest and amortization approach, Blue recognizes total first-year expenses of $1,101; expenses are recognized earlier with this approach but will decline in the lease’s later years as interest expense decreases.

Transition rules. FASB’s revised expo- sure draft indicates that lessees will not be required to adjust carrying amounts of assets and liabilities related to leases that are currently classified as capital leases; however, entities will be required to rec- ognize right-of-use assets and the corre- sponding liabilities for existing operating leases. These assets and liabilities will be measured as of the earliest comparative period presented in financial statements

Date Payment Interest Principal Liability

Lease inception on Jan. 1, 2014 $4,465.11

Jan. 1, 2014 1,000.00 — 1,000.00 3,465.11

Jan. 1, 2015 1,000.00 207.91 792.09 2,673.02

Jan. 1, 2016 1,000.00 160.38 839.62 1,833.40

Jan. 1, 2017 1,000.00 110.00 890.00 943.40

Jan. 1, 2018 1,000.00 56.60 943.40 —

EXHIBIT 4 Amortization of Blue Inc.’s Equipment Lease

The exposure draft

requires lessees to

recognize the exclusive

right to use an asset and

the related commitment

to pay for that right.

JUNE 2013 / THE CPA JOURNAL 31

issued after the new standard’s imple- mentation date. For example, if the standard becomes effective for fiscal years ending after December 15, 2015, the information for 2013 and 2014 will be reported in comparative 2015 financial statements, as though the new standard had been in place during those periods.

The transition rules instruct lessees to compute the lease liability by discounting the remaining lease payments (at the begin- ning of the earliest comparative period) at their incremental borrowing rate for each portfolio of leases with similar characteris- tics. If an existing operating lease is deter- mined to be a type B lease, the right-of-use asset recorded at the transition date is equal to the transition-date liability.

For type A leases, the right-of-use asset will be measured based upon the commencement-date lease payments. Specifically, the lessee will estimate the pres- ent value of the lease payments at the incep- tion of the lease contract. This presumes that the original lease agreement represents the original value remaining at the transition date.

For example, assume that a 10-year lease originally treated as an operating lease has seven years remaining at the transi- tion date. If the lessee estimates that the present value of the liability at the com- mencement date was $10,000, the right-of- use asset will be recorded at $7,000 at the date of transition ($10,000 multiplied by 70% remaining life). Furthermore, assume that the present value of the remaining lease payments at the transition date is $8,000. The lessee would recognize a $7,000 asset, an $8,000 liability, and a $1,000 adjustment to retained earnings.

Financial statement presentation and dis- closure. Lessees will be required to present total right-of-use assets and lease liabilities either as separate balance sheet line items or in the notes to their financial statements. In addition, FASB will require public enti- ties to present a reconciliation of opening and closing balances of lease liabilities, with separate reconciliations for type A and type B leases. Similar to current require- ments, FASB will require lessees to disclose any undiscounted commitments to make

lease payments for each of the next five years and the total commitments thereafter, with a reconciliation to the total lease liability.

Classification of lease payments in the lessee’s statement of cash flows will depend upon whether a lease is classified as a type A or type B lease. For type A leases, lessees will classify payments of principal as financing activities; cash paid for inter- est will be presented as an operating activ- ity. For type B leases, all cash payments will be classified as operating activities.

Impact on the Financial Statements The new lease accounting standard will

likely have significant effects on many enti- ties’ balance sheets. Exhibit 6 provides an estimate of the proposed standard’s impact on two publically traded companies: Target and Kohl’s. To estimate the potential effect on these companies, the authors utilized information about future lease payments in the companies’ lease notes, discounting the payments on an annual basis using the average borrowing rates provided. Beginning in the sixth year, the authors

As of/for the Year Current Ended 12/31/14 Standard Proposed Standard

Straight-Line Approach Interest and Amortization Approach

Balance Sheet

Assets $0 $3,673 Includes accumulated $3,572 Includes accumulated depreciation of $792 depreciation of $893

Liabilities—Lease $0 $3,465 Reduced by initial payment Reduced by initial payment of $1,000* $3,465 of $1,000*

Liabilities—Interest Payable — $208 Interest payable for one year $208 Interest payable for one ($3,465 × 6%)* year ($3,465 × 6%)*

Income Statement

Rent Expense $1,000 — — — —

Depreciation Expense — $792 Recorded depreciation of $893 Recorded depreciation of $792 ($1,000 – $208) $893 ($4,465/5)

Interest Expense — $208 Interest expense for one year $208 Interest expense for one ($3,365 × 6%)* year ($3,365 × 6%)*

Total Expense $1,000 $1,000 — $1,101 —

* See amortization schedule in Exhibit 4.

EXHIBIT 5 Comparison of Current and Proposed Standards for Blue Inc.

JUNE 2013 / THE CPA JOURNAL32

allocated the lump sum evenly to future years, based upon the amount of the pay- ment in the fifth year.

The resulting estimates are admittedly rough; they do not consider the likelihood that many lease payments are not made on an annual basis, and the authors lacked details on the timing of payments occur- ring beyond the next five years. Despite these limitations, the authors believe that these estimates serve to illustrate the sig- nificant changes that the new standard will bring to the balance sheets of lessees that have a substantial number of operating leases. They highlight the projected changes to the companies’ financial state- ments and ratios as a result of the capital- ization of existing leases.

This analysis assumes (based upon the information in the companies’ notes) that Target and Kohl’s primarily engage in the leasing of property (type B leases). As such, the authors assume almost no impact on the companies’ net income, because the companies would account for such leases using the straight-line method. The authors estimate that recording right-of-use assets for the operating leases would increase Target and Kohl’s total assets by 5% and 21%,

respectively. The most significant change for both companies would be the level of debt added to their balance sheets. Target’s long-term debt would increase by approxi- mately 16%; in the case of Kohl’s, long-term debt would increase by 66%.

Some financial ratios would also change significantly. Because of the increase in current lease-related liabilities, Target’s cur- rent ratio would decrease by 1%; the cur- rent ratio of Kohl’s current ratio would decrease by 8%. The changes in solvency ratios for Kohl’s would be very large—in particular, the company’s debt/equity ratio would increase from 0.64 to 1.06, or 66%. Furthermore, according to the authors’ estimates, the company’s return on assets would decline by 13% because of the increase in reported assets.

These large shifts, resulting from a reduc- tion in the company’s off–balance sheet financing, could represent significant con- cerns for creditors and investors, despite the fact that no contracts would have been altered and the economic circumstances of both companies would remain unchanged. The potential changes discussed above high- light the importance of preparing in advance for the potential new lease accounting rules.

Taking Steps to Prepare Although the revised exposure draft is not

yet implemented, there are several steps that lessees can take now to prepare, such as estimating the new rules’ financial report- ing implications, planning for additional pro- cesses that will need to be in place in order to ensure compliance, reviewing debt agree- ments and other documents for signs of changes in financial ratios that could result from the new standard, and considering the new rules’ implications for future lease agreements. The following sections explore these and other implications.

Estimate and communicate the likely financial reporting implications of the new rules. Because FASB has not yet issued a final set of new lease accounting rules, computing the precise effects that those rules will have on a lessee’s financial statements will be a challenging task. Lessees will likely see some changes in their patterns of expense recognition to the extent that they transition away from the straight- line approach that they now use for operat- ing leases; however, the most significant effects for many lessees will likely be the recognition of right-of-use assets and relat- ed liabilities on their balance sheets.

Target Kohl’s

Lease Percentage Lease Percentage Current Adjusted Change Current Adjusted Change

Current Assets $16,449 $16,449 — $4,775 $4,775 —

Total Assets $46,630 $49,002 5% $14,094 $17,056 21%

Current Liabilities $14,287 $14,472 1% $2,590 $2,811 9%

Debt—Long Term $13,697 $15,883 16% $4,150 $6,891 66%

Total Liabilities $30,809 $33,181 8% $7,586 $10,548 39%

Total Equity $15,821 $15,821 — $6,508 $6,508 —

Current Ratio 1.15 1.14 -- 1% 1.84 1.70 -- 8%

Debt/Equity 0.87 1.00 16% 0.64 1.06 66%

Debt/Assets 0.29 0.32 10% 0.29 0.40 38%

Liabilities/Assets 0.66 0.68 3% 0.54 0.62 15%

Return on Assets 0.06 0.06 — 0.08 0.07 -- 13%

EXHIBIT 6 Potential Financial Impact of Change in Leasing Standards

(Figures in Millions of Dollars)

JUNE 2013 / THE CPA JOURNAL 33

CPAs can begin to estimate the effects of the new lease accounting standard for their employers and clients by using the guide- lines offered in this discussion, as well as the content of FASB’s exposure draft, techni- cal plan, and project updates. These estimates should be shared with a company’s man- agement and board of directors so that they can prepare for the changes that will occur to the company’s balance sheet if the new leasing standard is implemented.

Coordinate with attorneys, lenders, and other parties to identify any agreements containing financial metrics or ratios. Lessees might have debt agreements con- taining covenants that reference balance sheet ratios. The implementation of new lease accounting rules could have signifi- cant effects on these ratios. Moreover, many companies’ current ratios, debt-to- equity ratios, and debt-to-assets ratios could change significantly after implementing the proposed rules.

If a lessee finds that moving off–bal- ance sheet operating leases onto the bal- ance sheet would place the company at risk of violating current agreements, such as debt covenants, management should consider communicating with counter- parties about these issues. Just as impor- tantly, if a lessee is in the process of negotiating new debt or other agreements that contain financial benchmarks and that will be in force after the implemen- tation of the new lease rules, the lessee should consider whether it will be able t o m e e t t h e a g r e e m e n t s ’ f i n a n c i a l benchmarks going forward. In short, early planning and consultation with counter- parties can help a lessee get a head start in demonstrating that a new set of leas- ing rules changes nothing about the lessee’s economic situation, only the manner in which the lessee reports its financial information to those outside the entity.

Plan for additional procedures. CPAs should begin planning for any additional procedures that they or the company will perform in connection with the imple- mentation of the proposed new lease accounting rules. For example, the addi- tion of several new right-of-use assets to lessees’ balance sheets could increase the need for impairment testing. Lessees with a significant number of operating leases under the current standards will need to put

systems into place to compute the initial right-of-use assets and liabilities related to those leases and to account for those leas- es on an ongoing basis after the imple- mentation of new rules.

CPAs should keep in mind that the cur- rent transition plan in the exposure draft is retroactive implementation, restating the ear- liest comparative period presented in finan- cial statements after the standard goes into effect. Advance planning for the effects that the new standard will have on attest engagements and accounting departments’ workloads will make implementation of the new rules smoother.

Monitor updates related to the expo- sure draft for lease accounting. It is entire- ly possible that the content of the exposure draft standard could change significantly before it becomes effective. CPAs should stay up to date on new developments by regularly checking FASB’s leasing project updates and by subscribing to FASB’s action alerts (http://www.fasb.org/ jsp/FASB/Page/SectionPage&cid=1218220 079432).

Looking to the Future Both U.S. and international lease

accounting standards are likely to change

significantly in the coming years. One of the most important changes might be the addition of a number of right-of-use assets and lease liabilities to lessees’ bal- ance sheets. In addition, expense recogni- tion patterns and lease disclosures are poised to change. As the authors’ estimates for Target and Kohl’s illustrate, some lessees could experience significant impacts to their financial statements under a new lease accounting standard.

CPAs should start preparing for the new rules now by following the steps described above. Knowledge of the direction in which the new rules are headed and care- ful preparation for the proposed standard will make the transition process smoother for CPAs. q

Mark E. Riley, PhD, CPA (Tex.), is an assistant professor in the department of a c c o u n t a n c y , N o r t h e r n I l l i n o i s University, DeKalb, Ill. Rebecca Toppe Shortridge, PhD, CPA (Ind.; inactive), i s t h e G a y l e n a n d J o a n n e L a r s o n Professor of Accountancy and the assis- tant department chair, also in the department of accountancy, Northern Illinois University.

Estimate and Communicate

Coordinate

Plan

Monitor

n Gather data on existing lease agreements.

n Estimate the financial statement impact of the new standard, espe- cially on operating leases.

n Communicate estimated financial statement impact to management and the board of directors.

n Identify banks and other counterparties to agreements containing financial statement–based terms and covenants.

n Coordinate with counterparties to ensure that the new rules do not negatively affect agreements.

n Based on existing and expected new lease agreements, identify key items to be measured and, if necessary, monitored for impairment or other purposes under the projected lease accounting standard.

n Plan for additional workload (e.g., additional audit-hours or time spent by accounting staff) entailed in completing necessary mea- surement and monitoring steps.

n Monitor developments to the standards-setting process. Consider subscribing to FASB’s action alerts.

EXHIBIT 7 Preparing for a Change in Lease Accounting

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