The second panel of the 15th Annual Financial Reporting Conference covered FASB’s new standard on accounting for leases. The standard, which is 500 pages long, will require a great deal of adjustment for preparers, auditors, and users.
The new standard, said Marc Siegel, is the result of a joint effort by FASB and the International Accounting Standards Board (IASB) to move operating leases onto the balance sheet. “My experience as an analyst was that investors were already consistently making adjustments to the financial statements to reflect the lease accounting,” he said. Mark LaMonte agreed, noting that Moody’s had used a complex formula for such purpose for many years. “The balance sheets are going to look pretty similar for international reporters and U.S. GAAP filers,” he said. “Where it’s going to be very different, however, is going to be on the income statement. Leases are going to be on the balance sheet, and the income statements are going to reflect that for IASB filers as though it was a purchase, but not so much for U.S. GAAP filers.”
Strauss then asked Amie Thuener about the scope of the standard: “They did limit the scope a little bit,” she said. “In current GAAP, if you’re involved in the asset while it’s being constructed, there are some circumstances where you have to treat that as a lease and put it on the balance sheet. Those rules go away under the new guidance, which some are really happy about.” Continuing, Thuener said that the difference between a service contract and a lease will become much more important. “As a user or a preparer, I can tell you that that’s going to be a lot of work.”
Turning to Prabhakar Kalavacherla, Strauss asked whether the new standard would cause problems for companies. “I think it will definitely pose some challenges,” Kalavacherla replied, “especially in the outsourcing industry and the utility industry.” The definition of control of the leased asset will be a particular sticking point, he said, noting that “whether they have a power to direct, did they design it and things of that nature” will be difficult for some companies to determine.
Kalavacherla then walked the audience through the basics of the standard. In short, lessees must record the noncancellable portion of the lease on the balance sheet for all leases lasting 12 months or longer. Renewal options should be taken into account only when the option is “reasonably certain to be exercised,” and the lease must be recorded at present value. Kalavacherla also noted that, because of feedback it received from constituents, FASB used a 12-month threshold that departs from the IASB’s guidance.
LaMonte speculated that “any company that’s focused on an EBITDA measure may actually strive for finance lease accounting, because they’ll have the amortization expense or depreciation expense, which is an add-back to EBITDA.”
Strauss asked Siegel to discuss the income statement and amortization. Siegel noted that during the comment period, U.S. constituents strongly advocated retaining the difference between operating and finance leases for profit and loss purposes. The IASB standard, in contrast, treats all leases as finance leases. “It’s really treating the lease like a purchase of an asset,” LaMonte said, “with an amortizing debt instrument like a mortgage.” He continued, “It’s not only the income statement that’s different for this type of lease, but the cash flow statement will be different, as well.” Interest will be included in the operating cash flow section, while principal will be in the financing section as repayment of debt.
Implications for Reporting
Strauss then asked whether issuers would try to categorize all leases as operating leases, as is common practice today. LaMonte speculated that “any company that’s focused on an EBITDA [earnings before interest, taxes, interest, and depreciation] measure may actually do the opposite and strive for finance lease accounting, because they’ll have the amortization expense or depreciation expense, which is an add-back to EBITDA.” Thuener added that “potentially, you may see more short-term leases.” She also said that while operating lease accounting would have the same income statement impact, “I’m not convinced it’s a lower cost and complexity; you have to do some gymnastics on the balance sheet, which I think will require big systems changes.”
Kalavacherla noted that amortizing a lease will set an effective limit on the expense amount that can be claimed on the income statement. This will require adjusting the amortization of the right-of-use asset by the remaining liability, which will cause the amortization amount to increase across the life of the lease. Kalavacherla called this “counter-intuitive,” but stressed that, “it’s a systems issue that we need to talk about.” Siegel explained that the “idea was to roughly approximate the straight-line expense that you have today from operating leases. So if you have a front-loaded interest component, then you have to have a back-ended amortization component of the asset.”
Siegel continued on the distinction between finance and operating leases: “The terms are very similar to what they are today,” he said, noting that four of the five criteria that distinguish finance leases are similar to those in current standards, and the new fifth one is in the same spirit. “In fact, if you wanted to interpret it the same way as you do today, and use the 75% and 90% brightlines, that’s not an unreasonable interpretation of the rules,” he said.
Kalavacherla speculated that “most small companies would like to go back to 75/90, because people are used to it, and it’s much easier to operationalize.” LaMonte talked about variable lease payments with respect to the finance versus operating distinction. “The variable lease payments in particular that you need to consider,” he said, “are those that are linked to some sort of index, such as CPI.” Modifications of lease terms would require remeasurement but would not be considered a new contract or affect a lease’s classification.
Thuener then discussed what separates a lease component in a contract from a non-lease component, the latter of which is excluded from lease payments under the new rule. “For example,” she said, “historically, executory costs like taxes, insurance, and maintenance were always expensed as incurred. But under the new guidance, taxes and insurance get included in the right-of-use asset, so you capitalize them.” Lessees must consider whether some activities really transfer a separate good or service and thus should be accounted for as separate, non-lease components.
Siegel covered how the reporting of initial direct costs will change. “The rules here are a little bit more restrictive than today,” he said, “but they are more consistent with how you capitalize other non-financial assets. You would only include costs that are incremental to the arrangements and would not have been incurred had the lease not actually been obtained.”
In contrast, accounting for lessors will not change much. “FASB did propose a lot of different amendments here,” Thuener said, “but ultimately settled on only pretty minor modifications.” The biggest change concerns profit recognition requirements, which were aligned with the new revenue recognition guidance, especially regarding the definition of control. “They also amended the lease classification criteria so that the requirements for both lessees and lessors are the same,” Thuener added.
Strauss turned to LaMonte to cover disclosure, noting that users and preparers classically differ on how much disclosure is appropriate. “I think the disclosures that are part of the standard are going to be pretty useful to financial statement users,” LaMonte said, adding that there will be both qualitative and quantitative improvements. “We’re still going to probably do some adjusting,” he said, “but we’ll have the information that will help us.”
From a preparer’s perspective, Thuener said that the adjustment would be “a lot of work. There’s some information that we may have to disclose that’s not even in a lease. How do we get that information? How do we have internal controls and processes to make sure that it’s right and timely? We’re thinking through that now.”
As to whether the international approach of classifying all leases as finance leases would have been preferable, LaMonte said his feelings are mixed: “If we’re looking at a nonfinancial company, we’re going to want the amortization and interest expense, because that’s how we look at their metrics. If we’re looking at Citibank and we want to measure a more pure net interest margin number, we don’t want this lease interest in the interest line. It’s hard to say one is preferable over the other.”
Wrapping up, Siegel said, “Sale and leaseback has changed a little bit, mostly for conforming amendments to try to align the revenue recognition. You’ve got to look at Topic 606 to see whether you’ve actually sold the underlying asset before the leaseback.” He also noted that smaller companies will be able to account for leases at a portfolio level rather than asset by asset.
Transitioning to the New Standard
Strauss turned to Thuener to outline the effective dates of the standard, which are 2019 for public companies and 2020 for nonpublic companies. “While people do have the election to early adopt,” she said, “I don’t know who’s going to, with the exception potentially of lessors, because some may consider adopting this standard early and revenue recognition on time so that they can align the two models.”
LaMonte remarked that the modified retrospective approach FASB has taken will “create a period of non-comparability for financial statement users, where the debt numbers and the asset numbers are going to look very different from one year to the next.” Kalavacherla elaborated, saying that he noticed that, for leases, “modified retrospective means you will go back and restate ’17 and ’18—but for revenue recognition, modified retrospective means cumulative catch-up.” He added, “Transition is always messy. It’s like getting onto the ramp of a highway—you’ve got to accelerate, you’ve got to think differently.”
Thuener discussed the cost of transition, saying, “You have to think about not just dollars, but also resources. One of the things that we’ve started thinking about is, who do we need to educate?” Google, she noted, has focused on the financial planning and analysis, information technology, and treasury departments. Reconciling the differences between the IASB and FASB standards will also be important, she said, as will the impact on key metrics, ratios, and book-to-tax differences.
Strauss opened the floor to the audience for questions. The first concerned the difference between a service and a lease, and how companies might try to reclassify the latter as the former to avoid the new rules. Siegel agreed that “the definition of a lease is going to be the new point of tension, without question,” but noted that “we have added a whole bunch of guidance around what the definition of a lease is, and a flowchart, so people should be able to understand it.”
Thuener said that the adjustment would be “a lot of work. There’s some information that we may have to disclose that’s not even in a lease.”
Another audience member asked why the implementation date of 2019 was chosen, especially considering the release of the revenue recognition standard in 2018. Siegel responded that feedback ultimately pointed them in the direction of splitting the releases. Kalavacherla added that “even if you postpone it to 2020, I don’t think anything will change—work gets expanded based on the deadlines. If the standard is really an improvement from an existing literature, why would you have a four- or five-year adoption?” LaMonte agreed, saying that “from a user perspective, we’d like to get this over with as soon as possible so we can start getting to that steady state.”