Equipment Leasing Plan Could Make Lessees Losers

Under the standard setters’ new proposal, companies that lease equipment could see their profits shrink in the early years of a contract, experts say.
Kathy HoffelderJuly 17, 2012

Since 2010, when the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) first published an exposure draft on lease accounting, the boards have been trying to come to an agreement on how to take two very different kinds of leases — equipment and rental — and account for them on the balance sheet. For years they had remained off balance sheet, typically in the footnotes of company financials.

Most industry participants readily accepted the need to put leases on the balance sheet and exempt short-dated leases of less than 12 months from the accounting standards, but for companies that lease equipment, that’s where the support ends.

FASB and the IASB’s June 13 proposal altered the way equipment leases treat lease costs in a company’s profit-and-loss statement. Under Approach 1, as it was dubbed, companies that lease equipment would now have to take into account interest and depreciation expenses. As such, they would have to provide higher interest charges at the beginning of a lease and lower charges at the end, a method commonly described as “front-loading.” Until now, interest charges on equipment in the income statement were typically consistent throughout a lease. A five-year lease, for example, would be charged the same amount to the income statement each period for five years.

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“The decision is bad news for most equipment lessees and possibly bad for lessors,” Bill Bosco, president of Leasing 101 and member of the FASB/IASB Lease Project working group, said in a recent comment for clients. He says the proposed front-loaded profit-and-loss cost pattern will be an extremely unpopular decision with equipment lessees. That’s because using that approach will create large deferred tax assets since the lease costs will be largely noncash charges in the early years of every lease, he notes. For a growing company, Bosco says, lease costs will never level off.

Kim Lamplough, a partner in the assurance division of Marcum LLP, an accounting and advisory firm, says the proposed new requirements for equipment leases will significantly affect market participants. “It will definitely change the timing of charges in the income statement and therefore impact net income” for lessees by diminishing it in the early years of a lease, she adds.

Under the new model for equipment lease expenses, Lamplough explains, the lease cost would be treated similarly to financing. And that would mark a big change from the way equipment lessees account for items now. “There would be a use component and an interest component. As with any financing, the interest charges are heavier at the front end because the principal amount is higher, so the interest component that’s going to go through the income statement related to those leases is higher at the beginning than at the end,” she says.

Since lease costs in the proposed accounting model for equipment lessees would be recognized too early, Bosco contends, it would also make early terminations challenging. Any time a front-loaded lease is terminated early, there would be a gain for the lessee on the balance sheet, an outcome he calls “not logical.”

Although the boards are only proposing the lease-accounting approaches, most industry participants expect the standards to remain in place. Lobbyists for equipment lessees are fighting the changes, but few believe the accounting method will actually be altered from its current state.

Besides Approach 1, the boards also came out with Approach 2, a plan for how to treat the rental payment in a company’s cash-flow statement. This plan, employing a straight-line method of accounting, recognizes a single lease expense over the entire life of the lease. The approach, which amortizes the rent expense in the income statement, is favored by many companies that lease property.

The boards began discussions in 2006 with the goal of providing investors and users of financial statements with a complete picture of a company’s leasing activities. FASB and the IASB believed previous accounting models that classified leases did not accurately represent lease information. After outreach discussions, the boards determined that most real estate lessees did not consider those transactions as having a financing component, though comments were a bit more divided over equipment leasing.

Both FASB and the IASB will have further discussions on lease accounting at a board meeting on July 19. A revised exposure draft is expected by the fourth quarter of 2012. Most expect few changes to be made to the provisions concerning equipment lessees.