It’s the Lease We Can Do

Written by Peter Kennedy, Director, for The Delaware Business Times

On behalf of the entire accounting profession all I can say is:

We’re sorry…. nostrae culpae….our bad….

I’m not talking about the recent Oscar flub (although if anyone from the Academy is reading this, my contact information is below if you’re looking to make a change).  No, this has to do with the coming changes to the Lease Accounting rules.

This change will take a relatively straightforward topic with a relatively straightforward accounting treatment, complicate it, and produce financial information that is (speaking for myself only) less meaningful and more confusing than before in most cases.

So why is the Financial Accounting Standards Board (FASB) doing it?  Well, if you’ve ever studied the financial statements of many airlines you may have noticed something missing – airplanes.  Similarly many big box retailers have few big box stores on their balance sheets.  What makes these situations possible are lease accounting rules that have been in place since 1976.  Currently if a lease term is less than 75% of the estimated useful life, the value of the payment stream is less than 90% of the estimated fair market value and there is no bargain purchase option at the end, it is considered an “operating” lease – you are temporarily renting and only expensing the lease payments over the course of the lease.  There is an entire cottage industry of accountants and attorneys who do nothing but design special entities and leasing structures that tiptoe across the bright line to qualify as operating leases – moving the airplanes and stores and more importantly the associated debt off of the balance sheet of the lessee.

This issue has stuck in the craw of the FASB for many years.  Clearly in the FASB’s mind, these are capital transactions masquerading as operating transactions by gaming the bright-line test mentioned above and I have to say they have a point.  The first exposure draft of the change was issued in 2010 – the FASB took the extraordinary step of issuing a second exposure draft after the hue and cry caused by the first proposal.  But the wait is almost over –  the final version was issued in 2016 and all non-public entities will be required to comply by 2020.    If you hope to present comparative statements, you will need to implement retroactively into the prior year also.

So what do the new rules look like?  Well, simplistically stated, they look very much like the current capital lease rules but they will apply to all leases.  If leasing activity is material, you must capitalize the estimated net present value of the lease payment stream – recognizing a “Right of Use” asset and an offsetting “Lease Payment” liability which will be amortized over the lease term.  The change does not just apply to JetBlue and Home Depot – no one is spared, from Fortune 500 down to very small nonprofit organizations.

Opponents have decried this change with concerns of: confusion on the part of financial statement users; accounting treatment driving people away from lease transactions that might make sense economically; bank covenants being thrown out of whack potentially compromising financing arrangements; exaggerated book vs. tax differences; locusts…..  Their objections have been duly noted, considered and ultimately disregarded in pursuit of a more pure accounting regime.  If you are interested in how I REALLY feel, my letter to the FASB in response to the exposure draft is linked here.

Like it or not, this change is coming and it would be a good idea to begin preparing by reviewing the change, assessing how your financial statements will appear after the change is implemented, and preparing financial statements users.