lease_vs_buy_1_.56003548643f9The Financial Accounting Standards Board (FASB) voted earlier this month to require companies involved in leasing arrangements to record all future lease obligations on the lessee’s balance sheets regardless of whether the leasing arrangement is deemed as operating or capital.

Lease Accounting Background

Under the current accounting standards, companies involved in leasing arrangements can account for a leasing transaction as a ‘capital’ or ‘operating’ lease. If a leasing-arrangement qualifies as a capital lease, the lessee must record on its balance sheet: (1) a liability representing the present value of the future obligations/payments related to the lease (i.e., capitalize the lease obligations), and (2) an associated asset (i.e., capitalize the lease asset). All leasing arrangements that do not qualify as a capital lease must be reported as an operating lease. Under an operating lease, all lease payments are treated as a rental expense and no asset or liability is recorded on the lessee’s balance sheet.

New Accounting GAAP for Leasing

As before, under a capital lease, companies would record a lease obligation and lease asset on their balance sheet. Companies would also recognize and present the interest on the lease liability separately from the amortization of the right-of-use asset on their income statement

The key accounting innovation is that companies with operating leases must now record a lease liability and a lease asset as in the case of a capital lease. Most other accounting treatments of operating leases would remain unchanged, i.e., the lessee would recognize a single lease expense, which combines the interest on the lease liability with the amortization of the right-of-use asset on a straight-line basis.

Thus, the new lease accounting potentially affects the lessee’s balance sheet composition without invoking much changes to the income statement. FASB is expected to finalize the new lease accounting by the end of 2016 and public companies must adopt the new lease standard starting from 2018/2019.

Consequences

A key advantage of the current lease accounting is that companies with operating leases can keep their obligations “off-balance-sheet,” or hidden, which means they underreport their financial leverage or indebtedness relative to other companies with capital lease arrangements. However, under the new rule, companies can no longer keep their lease obligations off-the-books which could adversely impact their debt ratings, ability to borrow cheaply, and investors’ risk perceptions.

As of 2014, the top ten companies with the largest lease rental expense (i.e., operating leases) include

Name of the company                                              Million dollars
VODAFONE GROUP PLC                                     3,420
WAL-MART STORES INC                                      2,800
SPRINT CORP                                                              2,600
FEDEX CORP                                                               2,443
NIPPON TELEGRAPH & TELEPHONE        2,230
FEDERAL EXPRESS CORP                                  1,418
MITSUBISHI UFJ FINANCIAL GRP                1,407
HITACHI LTD                                                               1,338
GAP INC                                                                         1,323
TJX COMPANIES INC                                            1,322

Assuming these rental payments are contractual obligations requiring payments over multiple years, we can expect trillions of dollars in historically off-balance-sheet leases to now get recorded onto the companies’ books.

While lately economies and companies have been emphasizing “de-leveraging,” accounting is motivated to undo that effect by requiring re-leveraging! A crucial question is whether the accounting ruling will have an economic effect on the leasing business. The accounting motivation for companies to prefer leasing over buying has been negated.

November 28, 2015; 8.06P

http://www.accountingweb.com/aa/standards/all-systems-go-for-fasb-lease-accounting-overhaul

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