The off-balance sheet accounting world has been rife with controversy since the late 1990’s, escalating with the Enron bankruptcy in 2001. As a result, in 2005, the SEC identified leasing as a form of off-balance sheet accounting that needed addressing and the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have been working together to reach an appropriate solution. While FASB and the IASB have not, as yet, managed to agree on how and when these lease accounting changes will be made, there is one thing we can be certain of: new rules are looming on the horizon with the inevitable penalties for non-compliance right behind them.
How did we get here?
Leasing is an important business activity for many companies – enabling access to assets, facilitating financing and reducing the company’s exposure to the risks of asset ownership. Many companies lease or rent assets – a floor of an office building, a store in a mall, equipment for manufacturing, trucks, cars and airplanes – the prevalence of which make it important for stakeholders, investors and financial statement readers to have a clear and complete understanding of the company’s leasing activities.
Currently, certain lease transactions are accounted for as “off-balance sheet,” meaning the assets and liabilities for particular leases do not appear on the company’s financial statements. This is conventionally done because current accounting rules use outdated bright line tests that are easily met by skilled bankers and accountants – the upshot of off balance sheet leasing is that companies’ debt to equity and leverage ratios are kept low.
Innovative companies are able to structure certain lease transactions to achieve off-balance sheet financing, meaning that certain large capital expenditures (and lease liabilities) are not captured on the financial statements. Here in lies the issue: certain leases should never be recorded as off-balance sheet. The temptation to hide significant expenses and liabilities off-balance sheet was made all too clear in the aftermath of the Enron scandal in 2001 (in their case hiding debts and losses in limited liability special purpose entities – that did not appear on any accounting statements), this drew the SEC’s attention and subsequently, they tasked the FASB and the IASB to improve and converge accounting principles for leases.
The Boards issued two exposure drafts – one in 2010 and one in 2013 (the revised ‘ED’) and have undertaken extensive outreach – including fieldwork meetings where members of the Boards and staff visited financial statement preparers, both public and nonpublic, lessees and lessors. During these meetings, the members of the Boards and staff met with more than 20 different companies, who provided detailed information about the types and volume of leases that they enter into, as well as the systems that they currently use to track their leases.
The purpose of these meetings was for the Boards and staff to use the information provided by the preparers to obtain a detailed understanding of the practical application of the 2013 revised Exposure Draft to help them evaluate the costs of implementation and any potential ongoing compliance costs. Following the conclusion of the comment letter process in September 2013, the Boards began re-deliberations raised by stakeholders. Unfortunately, and as all project managers will sympathize with, the desire for all parties to achieve a similar goal doesn’t assume they will agree to a similar approach.
For example, leases are currently classified as either capital (the asset being treated more like ownership and the corresponding liability treated like debt) or operating (the asset being treated like a rental arrangement), and the FASB is supportive of this dual approach – labeling capital leases Type A, and operating leases, Type B. Conversely, the IASB does not distinguish between the types of lease, preferring to present all leases as financings (i.e. as capital leases/Type A). Whilst such differences of opinion may not ultimately impact how leases are recorded on the financial statements, it does give one an idea of the sorts of issues the Boards are discussing.
Furthermore, in a July 2nd 2015 letter to the FASB, the Institute of Management Accountants (IMA) said that it had reservations about important parts of the overall project, including the definition of a lease, the classifications of the two types of leases, lessor accounting, lease modifications, initial direct costs and sale-leaseback transactions.
The good news is that the Boards do agree that companies should recognize the need for changes to the lease accounting rules for both lessees and lessors, although it is clear there is still some way to go before full agreement is reached. Industry experts expect a final accounting pronouncement to be published by the end of the fourth quarter 2015, with adoption of the accounting guidance being required by 2017.
What will companies need to do?
Lease accounting rules will change and, depending on the details, companies will need to ensure that all their leases are recorded and captured appropriately on their financial statements.
Companies will need to:
Consider and identify each asset as either owned or leased
Collate and identify every lease they are a party to
Ensure that the financial statements accurately reflect how each lease is recorded
Disclose in footnotes detailed information about the company’s leasing arrangements
What should I be doing today?
At this stage, it would be prudent for companies to ensure they have the tools in place to comply with these rule changes once the details become clearer. Having an effective process for monitoring proposed legislative changes is an excellent first step. Thomson Reuters has the access to information and the resources to help. Our teams across Legal and Tax and Accounting can partner with you and your outside counsel and strategic consultants to ensure business objectives are met.
For a project of this nature, as new rules are handed down, companies may have thousands of assets, leases and financial statements that will need reviewing.
Expertly trained professionals can:
Identify which assets are owned or leased according to the new rules
Review each lease, identifying and extracting the appropriate clauses to ensure appropriate steps are taken to record these on the financial statements
Review the financial statements to ensure these are recorded correctly
