The Financial Accounting Standards Board (FASB) has been working on a decade-long project that would materially alter the way many companies report leases on their financial statements. The changes, which are intended to address investors’ concerns, could have a far-reaching impact because leases are one of the most common types of transactions in the business world. And, many stakeholders have expressed concerns that the proposed changes investors are clamoring for will ultimately hurt businesses, cost jobs and upend loan covenants that require businesses to maintain certain debt-to-equity ratios.
A call for change
Under current U.S. Generally Accepted Accounting Principles and International Financial Reporting Standards, companies have to record on their balance sheets only lease obligations that are akin to financing arrangements. Examples include rent-to-own contracts for buildings or vehicles.
In practice, few leases appear on company balance sheets, however, because of the so-called “bright lines” in the accounting standards that give companies leeway to structure most deals to look like rentals. For decades, critics have complained that current accounting makes these businesses appear more financially secure than they really are, inhibiting the ability of investors and others to accurately evaluate these companies’ true financial situation. For some companies, such as airlines that lease their fleets of planes or retail chains that rent all their storefronts, lease payments make up significant financial obligations.
In 2013, the FASB released Proposed Accounting Standards Update No. 2013-270, Leases (Topic 842), to address these criticisms. The proposal was largely converged with the International Accounting Standards Board’s (IASB’s) Exposure Draft No. 2013-5, Leases. The boards have since disagreed on several aspects of the project and expect to publish separate final standards. Both standard-setters’ efforts have focused on the same central premise: Force lease expenses onto company balance sheets.
An uphill battle
When the Securities and Exchange Commission (SEC) advised the FASB to re-examine the accounting for lease contracts in 2005, it predicted that the project would generate significant controversy. “Many issuers see leasing as an attractive form of financing asset acquisition in part because leases can be structured so as to avoid recording debt,” said the SEC’s Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 On Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers.
Over the last decade, the project has sparked considerable opposition. In 2012, a study sponsored by the U.S. Chamber of Commerce estimated that the FASB’s plan would cost public companies $10.2 billion annually and result in the loss of 190,000 jobs. The same year, 62 members of Congress wrote to the FASB calling for a formal economic analysis of the proposed standard before publication.
More recently, U.S. Rep. Brad Sherman (D-Calif.) launched a renewed initiative against the proposed lease standard. In a letter to the FASB, the Congressman outlined specific concerns that he and “over 60 other members of Congress” have about the costs of complying with the update. He also demanded that the FASB perform a formal economic analysis of the planned standard.
In July, members of the FASB’s Private Company Council (PCC) said that they continue to reject the FASB’s plan to overhaul lease accounting. The PCC, which is made up of private company executives, auditors and creditors, believes that the changes will result in misleading financial statements and hurt small private businesses more than large publicly traded companies. Real estate and construction companies — which tend to rely heavily on fixed asset leases — also are expected to suffer disproportionate adverse effects compared with other industries.
FASB members presented a near unanimous front against the PCC, however, definitively stating their belief that lease obligations represent liabilities that belong on company balance sheets.
A watered-down proposal
Stakeholders’ criticisms haven’t fallen on deaf ears, however. The FASB has listened to feedback from roughly 1,740 comment letters, meetings with hundreds of individual organizations and 15 public roundtables. The result? FASB Chairman Russell Golden said that the FASB has made significant changes to the draft document to eliminate some of the biggest concerns about costs to businesses.
Most investors want the standard-setter to require businesses to record lease liabilities on their balance sheets. So, the lease standard will retain the requirement that companies record obligations to make payments on rentals of storefronts, equipment and vehicles as liabilities. But, in an effort to lessen the adverse effects of the new standard, the FASB has decided that operating leases — those that are more akin to rentals as opposed to financing deals — should continue to be accounted for in company income statements as they are today.
Year end final release
The FASB plans to publish its final lease standard by the end of the year. But don’t expect it to mirror the IASB standard. The boards have diverged on key parts of their proposals and no longer plan to issue joint final standards.
Also don’t expect the final standard to go into effect anytime soon. The implementation date is likely to be 2017 at the earliest and perhaps as late as 2019. Many companies have asked the FASB for a gradual phase-in to lessen the adverse financial statement effects.
When a new standard is published, talk to your financial advisor about how it will impact your financial statements and debt-to-equity ratios. Then discuss the anticipated changes with your lenders to preempt negative consequences related to loan covenant violations.