Operating the lease - a discussion paper

The FASB is looking to overhaul its 35 year old standard on Leases - FASB 13. This overhaul looks to have been directed with the convergence of the FASB and the IASB.

Both the bodies have recently issued a discussion paper on changing the way we account for operating leases. The discussion paper higlights the rationale to change the way we account for a "right to use assets" as described in EITF 01-08 or my earlier blog on embedded leases.

Under the current rule, Companies record finance lease obligations on the balance sheet while disclosing the operating lease obligations in the notes to accounts.

Under the discussion paper, the new rule will require companies to record operating lease obligations on the balance sheet as a liability and capitalise the right to use the asset as an asset, thereby making Companies look highly leveraged.

Broadly the implications of such a rule will have a bearing on the following

1. Balance sheets look highly leveraged (an estimate pegs the operating lease obligations for SEC listed companies at $1.25 trillion
2. Financial reporters will have to test for impairment on the capitalized operating lease assets in case of non-cancellable lease obligations
3. Operating lease obligations will be required to be recorded at fair values
4. In case of contingent rentals for operating lease assets, computing the value of the assets and obligations will be a nightmare
5. Periodic reassessment of the lease classifcation in case of constant renewal options/modifications coming in the agreement
6. Rental expenses now will be broken into rental expenses and interest costs (for the imputed value of the lease obligation)
7. A nightmare of companies who outsource work say for a period of 2 years under a non-cancellable lease - splicing the agreement into services and assets would take some doing

I welcome FASB's stance on recording the obligations and recording the assets on the balance sheet. This will make reporting more structured by ensuring stakeholders get to know as to whether an asset taken on an operating lease is impaired or not and the leverage of the balance sheet.

For instance financials of Airlines companies who lease planes on operating leases do not have any planes as assets on their balance sheets nor any liabilities. This is strange considering that from a going concern perspective airline companies cannot live without these planes. The new rule will reflect a clearer picture of the financial position of such companies.

The real problem will come to accountants when they address issues on contingent rentals, renewal clauses etc. These will be highly subjective from one company to the other and will render the purpose of meaningful comparasions among different companies baseless.

Well the proposed change is in mid 2011, hopefully by then we will have a lot more brightlines to easily account for the new OPERATING LEASE REGIME.