Lease accounting is back in the spotlight. After years of discussion, the IASB* and FASB* (the Boards) recently issued a new exposure draft, bringing changes that could echo through your business.
Leases allow companies to use property or equipment with payments made over time, and there has been debate whether the future payment obligations are debt. Today, payments due under operating leases aren't reflected on the balance sheet. But the Boards' new proposal requires that almost all leases be reflected on the balance sheet, with both an asset and obligation—similar to capital leases today. And the proposals create two methods for profit & loss statement (P&L) recognition.
If you lease, no matter your company's size or industry, your balance sheet will look different. Your P&L could, too. A more debt-laden balance sheet may prompt you to renegotiate current agreements; reshape how you weigh lease or buy decisions; and limit your company's ability to take on other debt. While further debate is expected, companies may need to begin planning now—particularly since the proposal requires retroactive restatement.
Where the business could feel the impact:
Before diving into the lease proposals, you'll need to consider whether you have a lease or just a service agreement. You'll also need to consider leases that are contained in a larger service agreement, such as if a company uses a third-party data center.
If your company has more than a few leasing agreements, it may be quite a task. Evaluating this now could save you time later.
Per the proposal, a lease must involve an identified asset. When an arrangement depends on the use of an asset, it needn't be specified in the contract.
If the asset is identified, you would then consider who's in control of the asset. In a lease, the party that can direct and benefit from use of the asset controls the asset.
Sometimes this analysis is straightforward: Assume a delivery company executes a contract with a vehicle manufacturer to use a fleet of trucks for a period of time. The agreement identifies the trucks and allows the delivery company to control how and when the trucks are used. This arrangement is a lease.
In contrast, assume a business hires a third-party service to deliver a parcel. It has no control over a particular truck, can't control the route, and shares the benefit of the truck with other customers. This is not a lease.
Not all assessments are this clear-cut; in some cases, the line between a lease contract and a service contract is blurry. Complications could include:
Leases with a maximum term of 12 months or less (including all possible renewal periods) do not need to be reflected on the balance sheet.
If you lease assets, your financial statements will be affected. The proposal aims for transparency and a clearer view of companies' total "debt." At a minimum, you'll want to understand how lease obligations could change your business's financial picture.
Under existing standards, leases are either operating or capital. Today, distinguishing between the two is based on bright-line tests, which allows one to manage contractual terms to achieve a desired accounting outcome. Those that fall under operating stay off the books and are treated as merely operating expenses.
Under the proposal, bright lines are gone. Virtually all leases will be capitalized on the balance sheet and measured based on the payments required over the lease term.
Depending on the size and extent of your leases, the balance sheet could look very different, with recognition of virtually all leases. This will lead to higher liabilities.
The proposal includes two possible P&L recognition patterns—a front-loaded recognition pattern typical of a financing (Type A); and a straight-line pattern (Type B) where the expense is spread evenly through the lease term.
The two new approaches place consumption of the underlying asset at its heart, instead of the four existing bright-line tests. This represents an important shift: Now, the nature of the underlying asset matters in financial reporting. So look at what's being leased and how it's being used.
Leases of property (land and buildings) will be presumed to qualify for Type B expense recognition. Type A would apply only if:
the lease is for the major part of the asset's remaining economic life, or the present value of payments accounts for substantially all of the asset's fair value.
For all non-property assets, the Type A recognition pattern applies. Type B is only permitted when: the lease is for an insignificant part of the economic life of the underlying asset, or the present value of future minimum lease payments is insignificant relative to the asset's fair value.
The presumptions above seem to follow the Boards' notion that most non-property leases are Type A, since an outright purchase is typically an option. This is often not an option for property leases.
Property or equipment? Defining leases as one or the other is critical—and possibly complex— under the new proposal.
Many non-property leases are operating today and will likely be Type A tomorrow.
You might presume that all structures affixed to land are property. But that isn't the case, as the Boards defined property narrowly— land, buildings or part of a building.
An additional wrinkle is that some contract components include characteristics of both. Assume a company executes an agreement to acquire electricity from the owner of a power plant. Assuming the arrangement is a lease, it's plausible that the turbine—not the building—is the primary asset. If so, the entire component would be evaluated as non-property.
Since equipment typically results in P&L recognition similar to other debt financing, the expense would be Type A. Similarly, leases involving land through which pipelines run or on which cell towers are located may actually require treatment as equipment, not property.
The threshold for equipment to qualify for Type B recognition—insignificant consumption—is well below the standards used today to classify leases as operating or capital. As such, most equipment leases will follow the front-loaded Type A financing model. This front-loaded recognition pattern will have a big impact when the asset is expensive—for example, an aircraft—or the aggregate leases are significant to your financial statements.
Insignificant won't be defined—it will be subject to interpretation. Companies must use their own judgment to determine the level of consumption needed to overcome the presumption.
Be careful interpreting this: With two options, the potential for error remains. And picking the incorrect one could misrepresent your P&L for that particular lease.
This decision is especially difficult to make if your equipment leases fall on the border of insignificant (e.g. a 3-year lease on a railcar that has an economic life in the 25- to 35-year range). It's likely that economic life will be the focus. This is because shorter-term leases generally attract higher relative payments to compensate for the higher relative costs (both initial as well as in the event of non-renewal).
Companies should voice their views on the new proposal. Submit your comments to the FASB by September 13, 2013. Before rules finally kick in, here are six steps to consider.
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Access a PDF copy of the article on PwC.com.
To have a deeper discussion about how changes in lease accounting may impact your business, please contact:
David Humphreys
Partner, National Professional Services Group
(973) 236 4023
david.humphreys@us.pwc.com
Chad Soares
Partner, National Professional Services Group
(973) 236 4569
chad.c.soares@us.pwc.com
Tom Wilkin
Partner, National Professional Services Group
(646) 471 7090
tom.wilkin@us.pwc.com
Krystyna Niemiec
Senior Manager, National Professional Services Group
(973) 236 5574
krystyna.niemiec@us.pwc.com
Sheri Wyatt
Director, Capital Markets and
Accounting Advisory Services
(703) 918 3602
sheri.wyatt@us.pwc.com
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