FASB moves ahead with debt simplification project
Simplifying and reinforcing the conceptual reporting framework will remain top priorities of the Financial Accounting Standards Board (FASB) in 2015. The classification of debt is one of its current targets. At its January meeting, FASB reiterated plans to eliminate the current rules and develop an overall principle for debt classification that’s aligned with International Financial Reporting Standards (IFRS).
Simple but transparent
In a recent speech at the American Institute of Certified Public Accountants (AICPA) conference, FASB chairman Russell Golden identified “clutter within our accounting standards” and the lack of a conceptual framework as reasons for inconsistent, complex financial reporting. He mentioned the classification of debt as one of 70 specific areas where companies and auditors feel there’s unnecessary complexity and there are costs that could be reduced by promoting simplification — without impacting the transparency to investors.
FASB included the debt project in its August 2014 simplification initiative, which focused on narrow, complex parts of U.S. Generally Accepted Accounting Principles (GAAP) and attempts to make relatively quick amendments. The board homed in on the presentation of debt on the balance sheet because the existing standard requires companies and auditors to consider specific rules that depend on the type of debt arrangement, such as a loan covenant, revolving credit and lock box arrangements, increasing-rate debt and callable debt. The current standard doesn’t include all scenarios, however.
The board wants the amended standard to include an overarching principle that will classify debt on the basis of a contract’s terms and the company’s compliance with the loan or bond covenants. A memo prepared for FASB’s January meeting states, “The introduction of a single principle, in place of rules-based guidance, is expected to reduce cost and complexity for preparers and auditors while improving the usefulness of the information reported to financial statement users.”
Current vs. long-term debt
Companies familiar with the prescriptive, rules-based guidance for classifying debt on their balance sheets may soon need to adapt to a looser principle that works for all debt arrangements. The change is important to companies that want to clearly distinguish between the debts that must be paid in the near term and the debts for which they have more time to pay.
When evaluating the liabilities section of the balance sheet, investors essentially want to know whether it looks like a company can meet its obligations over the next few months and how a company plans to manage its resources. Because long-term debt will be funded by future operations, investors see it as less burdensome than current obligations.
Under GAAP, companies must assess the details of their liabilities to distinguish between current and long-term debt. The AICPA defines current liabilities as “obligations whose liquidation is reasonably expected to require use of existing resources properly classified as current assets, or the creation of other current liabilities.” FASB considers debts as current if they mature within one year or the operating cycle, whichever is longer.
Accounts payable and current maturities of long-term debt are obvious examples of current liabilities. But the waters get muddier when dealing with debts that may be refinanced, hybrid contracts with elements of both debt and equity, contingent obligations and debts that will be settled with long-term assets.
Under FASB’s current proposal, a company’s debt would be labeled as noncurrent if it’s due to be settled more than a year after the reporting period, or if the business has the right to defer settlement for at least a year. This simple principles-based guideline takes its cue from International Accounting Standards 1, Presentation of Financial Statements. The proposed amendment would clarify that debt arrangements give a lender the right to receive money and require a borrower to make payments. It also would include guidance on what it means to have the right to defer settlement and examples of debt arrangements, making it clear that the list wasn’t comprehensive.
In addition, the proposed amendment would require companies to consider their legal rights in their debt contracts and make a determination based solely on those rights. The business wouldn’t consider whether it expects its lender to exercise its rights, such as calling for the debt to be settled earlier than expected.
Fewer rules, more judgment
As GAAP continues to replace prescriptive, rules-based standards with looser, principles-based standards, companies will need to adjust to a new mindset. Fortunately, your accounting advisor can help interpret how the proposed guidance on debt and other simplification projects may affect your company’s financial statements.
Spotlight on lease accounting disclosures
In January, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) met to discuss the proposed accounting standards for businesses that lease assets. As usual, the two rulemaking bodies largely “agreed to disagree” about how companies should disclose the more complex lease obligations in their footnotes. Here’s a closer look at the latest developments on the lease proposal, which remains a work in progress after more than a decade of joint collaboration.
Revising lease accounting
For years, investors and analysts have criticized the existing accounting rules that permitted many companies — including airlines, retail chains, real estate ventures and manufacturers — to keep lease expenses off their balance sheets and hide massive liabilities. FASB and the IASB started the long-running lease convergence project to make businesses around the globe report the expenses they have tied up in commitments to rent office space, warehouses, equipment and vehicles.
After years of meetings and numerous staff research projects, the boards still haven’t been able to come to a consensus on how to account for leases. They agree that lease obligations of more than 12 months should appear as liabilities on the balance sheet. But they disagree about how to report lease expenses on the income statement.
In 2013, FASB and the IASB issued the latest, mostly converged, proposals on how to report long-term lease contracts. But these proposals have been met by significant opposition, especially from U.S. businesses that don’t want to alter established reporting practices or report more debt to stakeholders.
Rather than continue to debate how to report lease expenses, the boards have shifted their attention to footnote disclosures for lease obligations. Businesses have criticized the disclosure requirements in FASB’s Proposed Accounting Standards Update (ASU) No. 2013-270, Leases (Topic 842), and the IASB’s Exposure Draft (ED) No. 2013-6, Leases, as being overly detailed and complex. On the other hand, investors want more insight into the types of rental arrangements businesses engage in to get a better picture of their overall financial obligations.
During the January meeting, the boards made some headway. Overall, they decided to retain the lease disclosure objective: “Enable investors to understand the amount, timing and uncertainty of cash flows arising from leases.” They also agreed to require companies to disclose information about various lease expenses and recommended (but did not require) the use of an investor-friendly tabular format that would include such information as:
- Short-term lease expense,
- Variable lease expense,
- Sublease expense,
- Cash paid for amounts included in the measurement of lease liabilities,
- Supplemental noncash information on leased assets,
- Weighted-average remaining lease term, and
- Gains and losses on sale and leaseback transactions.
In addition, the boards eliminated the requirement to disclose the reconciliations of opening and closing balances of lease liabilities and assets.
But that’s where the agreement ended. FASB voted to proceed with its proposed requirement to disclose a maturity analysis of lease liabilities, while the IASB decided to give businesses more leeway in determining whether to comply with the maturity analysis requirements.
For businesses with more complex, unusual or otherwise significant lease arrangements, the IASB is recommending business-specific disclosures. This may include information about variable lease payment terms, extension options and termination clauses, residual value guarantees and sale and leaseback transactions.
Looking to the future
After two formal proposals each and complaints from various stakeholders, FASB and the IASB haven’t been able to agree on how companies should account for leases on their financial statements. The boards now say their goal is to minimize the differences between U.S. Generally Accepted Accounting Principles and International Financial Reporting Standards, rather than produce identical accounting standards.
In a recent interview, FASB chairman Russell Golden reassured U.S. companies that the board would consider the impact that the lease standard would have on debt covenants and provide examples related to the definition of a lease. The boards plan to publish final standards sometime this year, but no official implementation date has been set.
Sidebar: Up-close look at income statement discrepancies
Achieving consensus on how to report leases on the balance sheet is fairly straightforward. But the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) are at odds when it comes to reporting lease expenses on the income statement.
The IASB wants all lease expenses to be treated as financing transactions, meaning interest and amortization would be calculated with rent expense. Because interest is calculated on a declining balance over time, the cost to rent a piece of equipment would look more expensive at the beginning of a lease. Many U.S. companies say such accounting treatment will make them look more leveraged than they are and diminish their market value and creditworthiness.
Conversely, FASB views some lease arrangements as financing transactions and others as simple rentals. Companies with rental-type contracts would report payments evenly over time. Businesses would decide how to account for their leases based on what the IASB believes is an arbitrary dividing line that will make the accounting more complex, which is counter to one of the project’s goals — to simplify financial reporting.
In a recent interview, FASB chairman Russell Golden agreed that investors would benefit from adjusting the balance sheet presentation of leases. But he doesn’t plan to change how leases are reported on the income statement, because it would be costly to implement and provide limited value to stakeholders.