Valuation experts will never look at income statements and balance sheets the same again under proposed changes designed to unite lease accounting around the world.
Almost all companies will be affected by the changes introduced by the agreement between the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) to create a new, converged approach to lease accounting that would eradicate the old distinction between operating and capital leases.
Exposure draft: The new Proposed Accounting Standards Update—Leases (Topic 842): a revision of the 2010 proposed FASB Accounting Standards Update, Leases (Topic 840) says that all assets and liabilities arising from leases must be recognized on the balance sheet. Critics of the current rules say they allow too many leased assets to be invisible, which means the books don't accurately reflect a company’s true financial picture. We agree.
Valuation experts need to understand the implications of the rule changes now because it is likely that existing leases will not be grandfathered. The changes will affect virtually all firms because leasing assets is so common. Of course, companies that lease assets to others will especially be affected.
Here are the main implications on company financials from the proposed changes:
- Balance sheets will grow, and companies will appear to be more leveraged;
- Lease expense will fluctuate because the lease will be amortized using the effective interest method, so the expense will be higher in the early years and lower in the later years (under operating leases, lease expense stayed constant); and
- Certain financial ratios could be affected because EBITDA would change, as lease expense would be replaced with interest and depreciation expense.
The IASB and FASB have been working together since 2002 to achieve convergence of IFRS and U.S. GAAP. The new converged standard for leases is part of this effort and is designed to significantly increase global comparability, which it will do because of the number of organizations that use leases.
The new exposure draft can be found on the websites of IASB and FASB.
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