As you may be aware, there are significant changes to lease accounting on the horizon. The impact will be significant to companies' balance sheets and specifically to the franchise community. Companies that have significant operating leases will see the biggest impact, although everyone will feel the effect in some capacity. The proposed standard is tentatively scheduled to be released in late 2013 with a possible effective date in 2017. In May 2013, the Financial Accounting Standards Board (FASB) re-released the Exposure Draft on Lease Accounting, which is expected to be the final version of the new lease accounting standard with comments due in September 2013. Private companies may see a one or two year deferral, which is consistent with new standards being issued greatly influenced by the recently established Private Company Council (PCC). The PCC is a new body that will work with FASB to determine whether and when to modify US GAAP for private companies.
Leasing is an important source of financing for many franchise companies. As a result and consistent with FASB views, it is important that lease accounting provides users of financial statements with a complete picture of a company's leasing activities. Under current accounting rules, leases are either capital (on-balance sheet) or operating (off-balance sheet). However, the current model has been criticized by financial statement users because it does not provide a meaningful representation of leasing activity. In particular, the current rules omit relevant information about rights and obligations that meet the definition of assets and liabilities. The current model has also been criticized given the “bright-line” distinction between capital leases and operating leases which may result in companies concluding differently on similar types of lease arrangements.
As a result of these concerns, FASB initiated a joint project with the International Accounting Standards Board to develop a new approach to lease accounting that would ensure that assets and liabilities arising under leases are recognized in the balance sheet – effectively eliminating operating leases. The proposed standard would require recognition, at the commencement of the lease, of an asset which represents the “right of use” of an underlying asset during the lease term and a liability representing its obligation to make lease payments. Both the asset and liability would be measured at the present value of the future lease payments using an appropriate discount rate.
In June 2012, the FASB modified its original exposure draft to allow for two methods to record the expense associated with these lease assets/liabilities. The first mainly applies to leases other than property unless certain criteria are met. This approach requires the amortization of the “right of use” assets on a systematic basis that reflects the pattern of consumption – typically straight-line. The liability would be recorded using the effective interest method. Interest expense and amortization would be recorded separately in the income statement and would be higher in the early stages of the lease. The second method applies to leases of property unless the term of the lease is over the majority of the expected life or the present value of the fixed lease payments account for substantially all of the fair value of the property. The liability would be recorded using the effective interest method. However, the “right of use” asset would be adjusted as a balancing figure such that the total lease expense would be recognized on a straight-line basis, regardless of the timing of lease payments. This expense recognition is consistent with the current leasing model. Rent expense under this method would be recognized as one amount in the income statement.
In determining the asset and liability, careful consideration is required for both the lease payments and lease term. Variable lease payments are included in the initial calculation and are reassessed at the end of each reporting period. Examples of such lease payments would be those tied CPI and sales levels at particular units. In-substance fixed lease payments structured as variable leases are also included in order to deter companies from not reflecting the lease on the balance sheet. The lease term to be used in the calculation is the non-cancellable period, for which the lessee has contracted, together with any options to extend the lease when there is significant economic incentive in which to do so. An example of such an incentive would be a franchised location with a 20 year franchise agreement and a 15 year operating lease with a 5 year renewal. Given the conditions in the franchise agreement, the lease term would be 20 years in the calculation of the asset and liability. Leases with terms less than 12 months, including all renewal periods, may use the current lease model which would require off balance sheet recognition and expense to be recorded on a straight-line method. However, very few leases would satisfy this requirement given the significant economic incentive threshold when determining renewal periods.
Additional disclosures are also required under the proposed standard. The disclosures primarily relate to reconciling the asset and liability to the balance sheet for each period. The PCC is currently working with the FASB to determine what, if any, disclosures should be optional for private companies. FASB initially considered related party leases although ultimately deferred to existing guidance on related parties. Most companies will adopt the new method on a prospective basis as allowed in the current exposure draft.
In order to prepare for the adoption of the new standard, companies should perform/consider the following related to their leasing activities:
- Develop a database/spreadsheet of all leasing activity in place including relevant terms, etc. to be used for adoption of the new standard
- Current debt covenants as the proposed standard would impact EBITDA and fixed costs coverage ratios, among others
- Future debt arrangements to ensure that the appropriate language is in place related to new accounting standards and modification of covenants
- Incentive compensation plans as EBITDA can change significantly under the new standard to the extent used in such calculations.
- Current and future lease negotiations and the related impact under the new standard including a careful analysis of payment and lease terms
- Related party leases
As you can see, the impact under the new lease standard is significant and a careful consideration of a company's leasing activity is required to avoid any unnecessary surprises. Companies should consider the above recommendations to assist with their preparation for the lease accounting change in addition to monitoring recent FASB developments during the proposal process. FASB has received many comment letters related to leases and has done a thorough job of vetting the issues as evidenced by the re-exposure of the standard. As such, please continue to voice concerns over the proposed standard as you come across specific issues at your company.