Accounting standards for leases are changing in an attempt to eliminate off-balance sheet transactions and accounting in U.S. and international financial reporting. One of the biggest changes is that operating leases as you know them will be eliminated.
Kamal D. Parag, partner with Habif, Arogeti & Wynne LLP, says the new proposal introduces the ‘right of use’ concept.
“You have a right of use of the leased asset, which has a value, and you have a corresponding lease obligation to pay for the right to use the asset,” Parag says. “Going forward, generally all leases would have to be capitalized on the balance sheet of a company.”
The current standards require companies to capitalize some leases if you meet certain requirements. If they don’t meet those requirements, companies can keep those leases off their balance sheet.
Smart Business spoke with Parag about how the changes will affect businesses, and how they can prepare.
What are some of the criteria leases must meet?
Generally, any lease of tangible property you have today and going forward would have to be capitalized on the books under this new proposal.
How can businesses accurately measure their assets’ value?
You would have to record the asset and lease obligation that are to be measured at the present value of the lease payments over the lease term. And the lease term would have to be determined by estimating the longest possible lease term that is more likely than not to be exercised. Similarly, you would have to consider contingent rental payments in determining this value.
So if you have a five-year lease with built-in options to extend at the end of the first five years for another five years, management has to make an estimate of how long they expect that lease will run. Will they just go the first five years and cancel, or will they stay longer?
That estimate has to be made at the inception of the lease. Then, at each financial statement reporting date, management is expected to reassess that estimate. If it changes significantly, they would have to adjust financial statements accordingly, thus resulting in volatility in earnings.
