Debunked: Four Myths about New Standards for Lease Accounting
By Bruce Pounder, CMA, CFM, DipIFR (ACCA); Director of Professional Programs, Loscalzo Associates, Ltd.
April 2011 (SmartPros) Most CPAs are aware that the Financial Accounting Standards Board (FASB) is changing the way lessors and lessees account for leases under U.S. Generally Accepted Accounting Principles (GAAP). Unfortunately, many CPAs have embraced one or more prevalent myths about how lease accounting will change. Those CPAs are likely to find themselves, their firms, and their clients unprepared for what's really coming. In this article, I'll debunk four common myths about forthcoming changes to lease-accounting standards.
Myth 1: “In the future, all leases will be capital leases.”
Under current U.S. GAAP, the specific accounting treatment that is applied to a lease varies greatly depending on whether the lease is classified as a capital lease or an operating lease. But the distinction between capital leases and operating leases is an artificial one, created by the FASB out of thin air decades ago. What the Board has proposed doing is eliminating that distinction and requiring all leases to be accounted for in the same way. As a result of eliminating the distinction, the terms “capital lease” and “operating lease” will have no meaning and no relevance under the forthcoming standards. And while the proposed provisions relating to the recognition, initial measurement, subsequent measurement, and derecognition of lease-related assets and liabilities have some similarities to current capital-lease accounting, the proposed provisions for all leases are significantly different from the corresponding provisions for capital leases under today’s U.S. GAAP. In short, leases will be accounted for under future standards in a manner that bears only minimal resemblance to current standards.
Myth 2: “For lessees, interest and amortization expenses will replace rent expense on the income statement.”
This myth pertains specifically to leases that are classified as operating leases under current U.S. GAAP. Today, the accounting for such leases is simple: the lessee recognizes periodic rent expense corresponding to periodic rent payments made to the lessor. Under the FASB’s proposed standards, it is true that lessees generally wouldn’t recognize rent expense while they would recognize interest and amortization expenses that lessees don’t recognize under current standards. The interest expense would arise from interest assumed to accrue on the lessee’s liability to make lease payments, while the amortization would arise from the systematic allocation of the historical cost of the lessee’s “right-of-use” asset. But the notion that one expense would be “replaced” by two new expenses isn’t quite true. Nor is the notion that rent expense would be “broken down” into two different components. In any given reporting period, the total dollar amount of interest and amortization expenses recognized under the proposed standards would almost never equal the dollar amount of rent expense that would be recognized under current standards. And for leases of machinery, equipment, and other property used in the production of goods and services, amortization expense might never be explicitly recognized due to the amortization being debited to Work-in-Process rather than being expensed.
Myth 3: “The FASB is bringing the lease-accounting provisions of International Financial Reporting Standards (IFRS) into U.S. GAAP.”
For many years, the FASB and the International Accounting Standards Board (IASB) have worked together to improve and converge the lease-accounting provisions of U.S. GAAP and IFRS. But contrary to popular belief, the FASB has never seriously considered incorporating the existing lease-accounting provisions of IFRS into U.S. GAAP. Nor has the IASB seriously considered incorporating the existing lease-accounting provisions of U.S. GAAP into IFRS. Instead, the Boards have focused on developing converged lease-accounting standards that are better than – and therefore different from -- either Board’s existing standards. So with regard to lease accounting, future U.S. GAAP and future IFRS will contain essentially identical provisions – but the provisions will be very different from anything found in U.S. GAAP or IFRS today.
Myth 4: “CPAs have plenty of time to prepare for the coming changes.”
This is possibly the most harmful myth for CPAs to embrace. Although the new standards are unlikely to be effective before 2015, the business implications of the changes that the FASB is contemplating will extend far beyond corporate accounting departments and audit firms. In particular, because the FASB is inclined to require entities to adopt the new standards retrospectively, there is a significant opportunity to avoid unnecessary costs and disruptions by not waiting until the last minute to prepare for the changes. Business implications of the coming changes include, but are not limited to:
As a result of the changes the FASB is planning to make to the lease-accounting provisions of U.S. GAAP, CPAs will need to completely re-learn the fundamentals of accounting for leases – including recognition, measurement, presentation, and disclosure. Fortunately, Loscalzo Associates’ 2012 FASB and AICPA Update course includes expert guidance on the practical steps CPAs should be taking this year to prepare for coming changes to the lease provisions of the FASB Accounting Standards Codification® (ASC).