Proposed Leasing Accounting Changes Will Have Substantial Impact on Manufacturers

The Equipment Leasing and Financing Association, a national trade organization representing companies in the $521 billion equipment finance sector, reported significant increases in leasing activity for 2011.

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Through leases for forklifts, vehicles, computers, production machinery and other items, manufacturers support that growth. Manufacturers, though, face substantial changes in how they account for such leases.

On August 17, 2010, the Financial Accounting Standards Board (FASB) in the United States, and the International Accounting Standards Board (IASB), released a joint exposure draft (called “Leases”) that proposes new leasing accounting requirements.

Objectives of the proposed standard include greater transparency, the elimination of off-balance-sheet obligations, and more faithful representations of leasing transactions.

The exposure draft reflects a general effort by the FASB and IASB to converge U.S. and international accounting standards. To further promote such convergence, U.S. GAAP (generally accepted accounting principles) and IFRS (international financial reporting standards) would be amended.

Under current lease accounting rules, a lease may be categorized as either a capital lease or an operating lease. Assets and liabilities for a capital lease are recognized on a manufacturer’s balance sheet. For an operating lease, however, assets and liabilities do not appear on the balance sheet: Payments are simply accounted for as expenses over the lease’s lifetime.

The proposed new standard would eliminate the operating lease category. An asset would be recorded for “right to use” and would be amortized over the lifespan of the lease. A liability would be recorded for the present value of future lease payments. Measurements would include accounting for options and contingent rentals, which would require estimates for uncertain future events.

Those changes would alter the way balance sheets and income statements are prepared. Lease agreements will need to be re-evaluated regularly to ensure compliance with the new guidance. The proposed standard also suggests that those requirements would apply to existing leases.

To properly evaluate a manufacturer’s financial performance, managers, investors and other stakeholders will need to familiarize themselves with the new lease accounting rules.

Those new rules will also affect existing loan covenants that manufacturers have with financial institutions. Many loan covenants include clauses related to balance sheet leverage and cash flow coverage. If a manufacturer’s financial performance fails to meet those measures, based on the new leasing rules, the loan will be regarded as being in technical default. The remaining loan balance will be considered a current liability.

To avoid such scenarios, manufacturers and their lenders will need to thoroughly examine existing covenants and determine how the new lease accounting rules will affect their ability to meet existing covenant clauses. Those covenants would need to be amended to acknowledge the impact of those new rules. To avoid technical defaults, these issues will need to be discussed and resolved before annual renewals of lines of credit and yearly note requirements take effect.

The comment period for the exposure draft ended December 15, 2010, and it has recently been announced that the FASB and IASB will re-expose the revised proposal for additional comments. The standard is expected to take effect on or after January 1, 2013.

How submitted comments will influence the standard’s final draft remains to be seen. Manufacturers, though, will face considerable change. They will need to monitor developments, revise lease accounting processes, educate investors, and amend existing loan covenants.

Jacob Nethery, CPA, is a senior manager in assurance services for Weaver, the largest independent accounting firm in the Southwest with offices throughout Texas. He can be reached at 817.882.7759 or at jacob.nethery@weaverllp.com.

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