Lease Accounting

Summary

  • FASB’s recently-approved standard to change lease accounting requires all operating leases to be recorded on the balance sheet at the present value of the expected future lease payments.
     
  • The new standard is expected to be issued in the first quarter of 2016, effective in 2018/2019 for private companies.
     
  • This change will impact the financial statements of banks and of their customers who lease equipment and real estate.  Leverage and debt-to-equity ratios will deteriorate, net income, EBTIDA, ROA, and operating cash flow will change.  Debt covenants will need to be renegotiated for many loans.
     
  • Many credit analysts and lending officers already make adjustments to current financial statements when analyzing borrower financial strength in order to take into account the impact of operating leases.
     
  • ABA's comment letter to FASB emphasizes the need for an in-depth cost/benefit study.
     
  • Due to efforts by many companies and the ABA, FASB's final standard will minimize change to expense and income recognition.
     
  • Expense recognition for operating leases will continue to be recognized on a straight-line basis, without any requirement to estimate variable lease payments. Further, option periods must be considered only if it is probable that the options will be exercised.
     
  • Changes to Lessor accounting are minimal and, while leveraged lease accounting is terminated, accounting for existing leveraged leases may continue. Income by lessors will be recognized as they currently are.
     
  • Bankers should analyze the impact on their capital and leverage ratios.
     
  • Upon final issuance of the lease accounting standard, ABA will be engaging regulators to address regulatory capital and leverage ratio requirements. If you would like to be involved in this effort, please contact Mike Gullette.
     
  • Due to efforts by many companies and the ABA, FASB's final standard will minimize change to expense and income recognition.
     
  • Expense recognition for operating leases will continue to be recognized on a straight-line basis, without any requirement to estimate variable lease payments. Further, option periods must be considered only if it is probable that the options will be exercised.
     
  • Changes to Lessor accounting are minimal and, while leveraged lease accounting is terminated, accounting for existing leveraged leases may continue. Income by lessors be recognized as they currently are.
     
  • Bankers should analyze the impact on their capital and leverage ratios.
     
  • Upon final issuance of the lease accounting standard, ABA will be engaging regulators to address regulatory capital and leverage ratio requirements. If you would like to be involved in the effort, please contact Mike Gullette
     

Background

In May 2013, The Financial Accounting Standards Board (FASB) issued an exposure draft (ED), proposing to significantly change lease accounting. The comment period for the ED ends in September. In short, the main change is that ALL leases will be required to be capitalized on the balance sheet, as capital leases are treated today. This has a number of implications:

  • Similar to what is required for all capital leases, a leasing asset (referred to as the “right of use” asset) and an accompanying “lease liability” is recorded by the lessee (the party renting the property from the owner), measured at the net present value of expected payments (excluding contingent payments, such as those based on sales).
     
  • The amount of the asset at inception will be the present value of the expected payments, not including contingent rent or renewal options, unless the renewal terms a significant economic incentive to exercise the option.
     
  • Most leases of equipment will recognize expense similar to how capital leases are today, with higher expenses (due to interest expense) recognized during the early years of the lease and lower expenses during the later years.
     
  • Most leases of real estate will be expensed in a straight-line fashion, much like operating leases are today. The expense is the cash payment, adjusted for contractual increases already known.

Analysis

Changes to financial statements of banks and their borrower customers will be vast.

  • As a result of these changes, the following changes to bank financial statements will occur, unless the regulations are changed. 

    - Leverage ratios will deteriorate
    - Fixed asset ratios will be higher
    - Risk-based assets will increase
     
  • As a result of these changes, the following changes to financial statements of borrowers will occur.  Loan covenants and key financial analysis will have to change as a result:

    - Leverage ratios, such as long-term debt-to-equity, will change
    - Fixed asset ratios will be higher

The impact of the change on the economy is not clear

 ABA realizes that investment and lending decisions may change if the proposal is approved.  However, we have not yet seen convincing evidence of the impact such changes will bring to the overall economy.  For example, while this may hurt the leasing business, it may increase the demand to directly own land and equipment.  Shorter leases may be in higher demand, though that may increase those rates overall.  It should also be noted that there are various other advantages for leasing equipment and land than merely the current “off-balance sheet” treatment. Therefore, it is very tough to determine the long-term impact of a change.

Bankers can make a claim that the deterioration of leverage ratios can hinder lending.  This is a legitimate concern.  However, FASB believes that regulators will consider changes in regulatory capital and leverage ratios and FDIC assessments once the final standards are approved.  ABA agrees, though it is not clear whether regulators will make the appropriate adjustments to the regulations or will just accept them, thereby effectively causing the accounting change to be a de facto increase to required capital.  The banking agencies have not indicated how they will treat such a change (and, as a matter of policy, will not perform an analysis until a final standard is issued).  ABA will, therefore, be addressing the regulators separately.

​Questions? Please contact Mike Gullette, Vice President, Accounting and Financial Management for more information.