By Rebecca Tonn
This summer, the Financial Accounting Standards Board will issue a proposal for review and comment that would change how public and private businesses account for leases.
Businesses use either “capital” leases or “operating” leases.
A capital lease involves leasing an asset, such as vehicle, warehouse, property or heavy equipment for most of its economic life. For an automobile, a capital lease could be 10 years, but for a warehouse, it could be 40 years.
An operating lease is short-term, such as a one-year automobile lease.
Currently, a capital lease must be recorded as an asset and a debt — a lease payable — on a financial statement. But an operating lease is not recorded as an asset or liability on a balance sheet.
“But you do have to disclose it in the footnotes of your financial statements as a commitment,” said Rob MaCoy, CPA and partner with BKD LLP.
“But, conceptually, this will change everything to a capital lease. The theory behind it, if you will, is that when a business signs an agreement to lease a car for a year, they have a liability to pay.”
And the business has the “right to use” the asset.
The proposed change was prompted by the need to ensure that leases are accounted for consistently across sectors and industries, according to a FASB report.
Both International Financial Reporting Standards and U.S. Generally Accepted Accounting Principles split leases into separate categories.
Although total leasing volume in the United States during 2007 was $760 billion, many of these lease contracts were not recorded on companies’ balance sheets because they are operating leases.
“The split between finance leases and operating leases can result in similar transactions being accounted for very differently, reducing comparability for users of financial statements,” the FASB report said.
Business owners need to prepare for the change because it can affect them in several areas.
The FASB change will not have an effect on a company’s cash flow, but it will change a company’s debt to equity ratio for those that have loan covenants with a bank or financial institution.
“So, even though your equity has not changed, and your cash flow has not changed — your liability has increased, and you could fail a debt covenant,” MaCoy said.
He said the FASB proposal is changing the business language.
“And our concern is how soon the users of financial statements (banks, financial institutions and investors) will understand the change and adapt their loan covenant requirements,” he said.
Certain benchmarks, including debt to equity ratios, may need to be adjusted as users read financial statements.
And, MaCoy recommends that small business owners use caution before entering into any long-term debt agreements between now and when the proposal is finalized.
FASB and the International Accounting Standards Board issued a joint discussion paper, “Leases: Preliminary Views,” during March 2009, stating that both boards agree to this concept.
After the review and comment period, FASB will either issue a final draft with modifications or if it has to be changed extensively, they will reissue it for review.