More or Lease

How a proposed accounting standard could change your balance sheet

Back Article Jul 1, 2011 By Bill Romanelli

Exciting news in the accounting world might sound like an oxymoron, but this is the post-Enron and post-housing bubble economy. The guys and gals in the green eyeshades are under a new spotlight, and the changes they’re making to the practice of accounting are more than just fodder for ledgers. They are paradigm shifts in how companies and organizations calculate the bottom line.

Recently, the two major organizations of the accounting profession, the International Accounting Standards Board and the U.S. Financial Accounting Standards Board, proposed a change in lease accounting that has a direct result on a company’s balance sheet.

Leases for anything from copiers and equipment to real estate are categorized as either operating leases or capital leases under current standards. Explaining the differences between the two requires a discussion on accounting theory, so suffice to say that operating leases are not line items on the balance sheet, but capital leases are. The preference, of course, has been to categorize a lease as operational whenever possible, so it won’t show up as a liability.

“In effect, the new standard would eliminate operating leases,” says Tom Perry-Smith, partner with Perry-Smith LLP. “For companies with a large portfolio of operating leases, this could mean a significant shift in the complexion of their financial statements. All of a sudden, they’ll have a huge load of new financial obligations (i.e., debts) they didn’t have the day before. That can impact their ability to borrow money and change the perspective on the company’s overall financial position.”

Importantly, the new standards would require organizations to list the current value of the entire lease agreement (not just the leasing costs for that fiscal year) as a liability on the balance sheet. A company that currently pays $1 million a year on leased equipment, for example, would have to post a liability of approximately $5 million if it has a five-year lease agreement for that equipment.

That said, equipment leases in most cases could be a secondary â?¨concern.

“For many businesses, the largest impact on financial statements will be that of their real estate leases, which are typically longer and of higher value than equipment leases (although there are exceptions),” Perry-Smith says. “That’s why it will be vitally important for organizations — as well as their shareholders and creditors — to have a clear understanding of how those balance sheets are going to change.”

The proposed rules would also require the company to make a corresponding entry on the asset side as if they actually own the equipment or property. That might make it a zero-sum game in terms of equity, but it could wreak havoc on the organization’s debt ratio.

“Lenders and borrowers agree to certain covenants, one of which is that the borrower’s overall debt cannot exceed a certain ratio, such as 1-to-1 or 2-to-1, or the lender can call in the loan,” says Don Pfluger, partner with Gallina LLP. “Under the proposed rules, a company could literally blow out the debt ratio and go to something like 4-to-1 or more overnight. Lenders will have to either call the loans or modify their loan covenants.”

That could mean creating covenants that look bad on paper. Given the current economy and events of the past three years, that’s not an appealing option for lenders.

“For many businesses, the largest impact on financial statements will be that of their real estate leases, which are typically longer and of higher value than equipment leases.”

Tom Perry-Smith, partner, Perry-Smith LLP

Needless to say, the proposed rules aren’t warmly embraced by the entire industry. According to a Deloitte survey of U.S. companies, 80 percent of respondents say the new standards will place a significant burden on financial reporting, 68 percent said the changes would have a “material impact” on their debt-to-equity ratios, and 40 percent said the new standards would make it more difficult to obtain financing. Both accounting organizations have received more than 700 comments from industry professionals. Not all are in opposition, but it’s fair to say a healthy percentage falls into the category of, “If it ain’t broke, don’t fix it.”

“Operating leases are already required to be disclosed in the footnotes of the balance sheet,” Pfluger says. “The information is already there; this won’t make financial statements any more accurate. The current method has been working fine since the 1970s. I’m just not sure why there’s a drive to make this particular change right now.”

Both accounting standards boards say the proposed rules would not only improve the financial information available to investors, but would also result in a more consistent approach to lease accounting for both lessees and lessors.

In a prepared statement, FASB then-Chairman Bob Herz said: “The proposal is intended to improve the transparency of lease accounting and also decrease its current complexity.”

With public trust in corporate America free-falling to levels not seen since the worldwide financial crisis of 2009 (according to the 2011 Edelman Trust Barometer), a little more conservatism on the balance sheet may be inevitable. That said, the proposed standards are still a long way from implementation.

The first discussion paper on the proposed rule was issued in 2009, according to Shawn Tabak, a director of accounting advisory services with KPMG. That was followed in August 2010 by an “exposure draft” of the new standard and a comment period that ran until Dec. 15. Both FASB and IASB have been reviewing the comments, deliberating the proposal and fine-tuning.

“There’s no specific timeline for implementation at this point,” Tabak says. “They’re working on it. That’s all we know.”

Perry-Smith agrees, saying he doesn’t expect the proposed rules to take effect, whatever their final form, until 2013 or 2014. Besides, according to the Deloitte survey, 93 percent of U.S. companies aren’t ready to implement the proposed changes anyway.

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