New Lease Standards May Demand Two Sets of Books

The just released IASB lease accounting standard and its forthcoming FASB counterpart call for different expense accounting methods.
David KatzJanuary 13, 2016
New Lease Standards May Demand Two Sets of Books

Launching an era in which many U.S.-based multinationals may be required to keep two sets of books on their leasing arrangements, the International Accounting Standards Board issued its new lease accounting standards late on Tuesday.

462358069Still to come are the U.S. Financial Accounting Standards Board’s lease accounting standards, which FASB has said would be issued in the first quarter of 2016. Both measures would require public filers to report the results of their lease deals on their balance sheets and income statements, rather than in the footnotes to their financial statements.

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In any event, the clock has started ticking for companies who file at least part of their financials related to leasing under International Financial Reporting Standards. The new IFRS leasing standard will become effective on January 1, 2019. Companies that also apply another IASB standard, Revenue from Contracts with Customers, can apply for early adoption.

In November, FASB voted to proceed with its own leasing standard, which would be effective for public companies for fiscal years (and interim periods within those fiscal years) starting after December 15, 2018. For private companies, it would be effective for yearly periods beginning after December 15, 2019. The board will permit companies to adopt the measure early once the standard is published.

After attempting to converge on a single lease accounting rule in a project they launched in 2006, the two boards agreed, in effect, to disagree about the issue in 2014. That divergence set the stage for a situation in which certain U.S.-based multinationals would have to account for their lease deals under two different financial reporting systems: U.S. GAAP and IFRS.

The key difference between the two standards concerns how corporate lease customers should report lease expenses on their income statements. In its new standard, IASB has decided to classify all leases as finance leases (also known as capital leases), thus removing the prior distinction between operating leases and finance leases.

The new IFRS standard replaces the previous method of expensing operating leases in equal amounts on a straight line. Now, such expenses will be front-loaded and then depreciated over time. Companies will also have to report the present value of interest costs on lease liabilities.

The difference between the expense-accounting methods in the IASB and the FASB standards is that, in contrast to IASB’s single way of doing it, FASB will require a dual approach. The dual approach would maintain the distinction between operating and capital leases.

Under the forthcoming FASB standard, for most operating leases (called Type B leases), a company would recognize a single lease expense in the income statement, recognized on a straight-line basis. For other leases (called Type A leases), a company would recognize depreciation of lease assets separately from interest on lease liabilities.

That difference could create a big operational challenge for U.S. multinationals with a substantial overseas presence, according to Sean Torr, a director of the Deloitte Advisory unit at Deloitte & Touche LLP. Particularly burdened would be a U.S. company that reports its consolidated financials in U.S. GAAP but has subsidiaries that report in IFRS.

While the data-gathering effort will basically be the same, such parent companies will have to perform calculations to align single-method subsidiaries with the dual-method approach, according to Torr.

Going forward, companies will have to keep a tight rein on their controls over how accounts affected by leasing are reconciled. “Maybe things [will] go well in the beginning,” but finance and accounting departments will have to make sure that the reconciliation process doesn’t “get out of control as time passes,” he says.

“You’re basically going to have to manage into the future two sets of books as they relate to [lease] accounting for those subsidiaries that have IFRS and U.S. GAAP reporting,” Torr added.

While the difference in expense accounting under the two systems is “not a show stopper,” it’s “an incremental challenge that global companies will have to deal with,” according to the Deloitte accountant.

Nevertheless, both standards agree on the most significant aspect of their revisions of lease accounting: all lease assets and liabilities must now appear on corporate balance sheets.

To be sure, under previous IFRS dictates, leases found to be economically similar to purchases of the underlying asset were classified as a finance lease and reported on a company’s balance sheet. But all other leases were classified as operating leases and not reported on a company’s balance sheet.

Off-balance sheet leases were accounted for in the same way as service contracts, with companies reporting rental costs via the straight-line method on their income statements.

As a result, most leasing transactions were not reported on company balance sheets. Listed companies using IFRS or U.S. GAAP disclosed almost $3 trillion of off-balance-sheet lease commitments in 2014, according to IASB.

The lack of transparency inflamed financial regulators on both sides of the Atlantic, leading them in the new standards to make sure balance sheets would fully reflect lease finance.

For corporate leasing customers, the most significant effect of the new requirements in the IFRS standards will thus “be an increase in lease assets and financial liabilities,” according to IASB’s summary of the project.

“Accordingly, for companies with material off-balance sheet leases, there will be a change to key financial metrics derived from the company’s assets and liabilities (for example, leverage ratios),” the board reported.

In other words, the typical change for most companies is that they will find themselves with larger assets and liabilities and a larger balance sheet overall, according to Torr.

As with any large accounting change, key stakeholders will be asking CFOs about the effects of the new leasing standards on company finances. “The auditors are going to be asking, analysts will start asking, and being ready with at least a way to get to an answer is going to be important to the CFO and the CFO’s teams,” he says.

Because of the uncertainty regarding the final standards and because the boards’  converged revenue recognition standard has needed a great deal of attention, “companies haven’t been as focused on keeping current about the leasing as they might have been, Torr added. “That will be accelerating because the timeline is not a very long [one] to implement.”

One area in which substantial time may be needed for compliance with the leasing standards is data gathering. “It’s a significant undertaking,” he said, noting that parent companies are likely to have many more data elements to cope with per lease, as well as differences in language and in contracting at their subsidiaries.

Another potential area of complication in data gathering “is that it’s a moving target,” Torr said. “Over the three years of implementation, you have a [lease] portfolio that’s renewing, modifying, and cancelling. And the maintenance of that portfolio data…is a long lead-time activity.”

Finding and setting up the technology to process compliance with the new leasing regime is also likely to demand a long lead-time. Companies will need “a solution in place that will manage these new calculations, store the data, and facilitate the analysis and reporting that’s required by the standard,” he added.

Replacing accounting rules introduced more than 30 years ago, the new IASB standard does give filers a bye on one small item, however. It doesn’t require companies to report financial results related to short-term leases (leases of less than 12 months) and leases of low-value assets such as personal computers.