Over a decade ago, the improper treatment of leases by Xerox Corporation sent shock waves through the financial and accounting professions. Recently, the International Accounting Standards Board met with the U.S. Financial Accounting Standards Board in an attempt to reach consensus about how to consistently record and report leases on financial statements.
As the accounting profession continues to seek convergence between accounting principles generally accepted in the United States (GAAP) and International Standards, companies and organizations across the U.S. continue to utilize leases to finance the growth of their operations.
For most companies, the decision about whether to purchase or lease an operating asset is not so much about how it will be reported on their financial statements as it is about cash flow and the anticipated timing of business plans. For some, the prospect of entering into an operating lease and keeping that off the balance sheet (as a liability) is very enticing.
However, the prospect of capitalizing operating leases on a company’s balance sheet is looming in this proposed convergence and, if passed, could have a significant impact on your financial reporting.
For example, if ABC Company leases their corporate offices for $12,000 a month, they expense $12,000 a month and disclose the 10-year length of their lease term in the footnotes to their financial statements along with the related future minimum payments. There is no asset or liability recorded on their balance sheet under GAAP.
Under international standards, at the inception of their office lease, ABC Company would record an asset for the right to use that office space and a liability that represents their future payments on that lease – for the term of the expected use of that asset. With a monthly $12,000 payment ($144,000 annually) for 10 years, it is easy to understand why adding an asset and related liability to ABC Company’s balance sheet would cause a significant change to their financial statement presentation.
Beyond financial reporting, any agreements tied to the balance sheet of ABC Company, or related financial metrics, would be impacted – namely covenants on commercial financing agreements.
The FASB and IASB did not reach a consensus when they met last month about convergence of lease standards, but they did not give up on seeking consensus, either. This will continue to be an area of focus for standard-setters. In the meantime, companies don’t need to change their financing plans, but should be vigilant of the impact future changes in accounting policy could have on them.
For more information about accounting for leases, contact Mike Bedel at (317) 613-7852 or email [email protected].