Financial Accounting Standards Board Exposure Draft – Leases (Topic 840)

Changes in Way the World Accounts for Leases

A Bit of History

In 1957 two former Baltimore Colt football players, Alan Ameche and Gino Marchetti, joined with a friend and founded Gino's Hamburgers in Baltimore, MD. The fast food restaurant proved to be very popular and expanded rapidly throughout the Mid-Atlantic region. Rather than franchising its stores, Gino's owned and operated all of its units. To provide the financing necessary for the growth and expansion of the company, Gino's sold stock to the public that was traded on the New York Stock Exchange. According to various sources, by 1982, Gino's consisted of 359 Gino's Hamburgers locations along with other restaurants that brought the total number of units to more than 500. In 1968, the Marriott Corporation had founded the Roy Rogers Restaurant chain. By 1982, Marriott was looking to quickly expand the presence of that brand in the Washington, DC/Baltimore region and acquired the Gino's restaurant chain for $48.6 million. Once the acquisition was complete, Marriott converted 180 of the Gino's Hamburger locations to Roy Rogers Restaurants and closed the remaining locations that were in poor quality locations or in close proximity to an existing Roy Rogers.

Far from desiring to continue the operations of Gino's, Marriott's acquisition was driven by the goal of expanding the footprint of its own fast food chain. Gino's presented this opportunity as it already controlled the leases on desirable locations in areas Marriott was targeting. Clearly, the operating leases held by Gino's had some value that Marriott was willing to pay over $48 million for; however, in 1982 the operating leases were not reflected as an asset of Gino's in the company financial statements. The same accounting treatment of these leases that was effective in 1982 continues today.

Theory Underlying the Proposed Changes

According to the Financial Accounting Standards Board (FASB) web site, FASB "Concepts Statements guide the Board in developing sound accounting principles and provide the Board and its constituents with an understanding of the appropriate content and inherent limitations of financial reporting." Although they do not establish generally accepted accounting principles (GAAP), the Concepts Statements provide the theory that underlies the pronouncements establishing GAAP.

Originally issued in 1985, Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements, provides a definition for both assets and liabilities. Assets are defined as "probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events." Liabilities are defined as "probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events."

In the case of the acquisition of Gino's, it appears that Marriott believed that the operating leases held by Gino's would provide future economic benefits by allowing for the expansion of their own fast food chain, indicating that these operating leases were an asset held by Gino's.

The International Accounting Standards Board (IASB) and FASB have identified leasing as an important source and form of finance. Accordingly, the Boards believe "that lease accounting should provide users of financial statements with a complete and understandable picture of an entity's leasing activities." The existing model of accounting for leases as either operating or capital under U.S. GAAP has been criticized for its complexity, its failure to properly represent lease transactions in accordance with the definitions of assets and liabilities contained in the underlying FASB Concepts Statement, and for the fact that it enables the structuring of leases to reach a desired accounting outcome.

The Proposed New Lease Accounting Model:

Timing and Scope

After a multi-year process of reconsidering the accounting treatment for leases, the FASB and IASB issued an Exposure Draft on August 17, 2010 that provided a new model for lease accounting. Although both Boards are accepting comments and responses to questions on this Exposure Draft through December 15, 2010, it appears likely that much of what is in the current model will be retained when the final form of the standard is released. The Exposure Draft does not contain an effective date, but when the Boards originally began work on the proposed model, the goal was to have the standard issued in final form by mid-2011 with adoption potentially required in 2012.

The proposed changes are likely to affect almost every entity that prepares GAAP-basis financial statements, as the standard would apply to any lease that is entered into after adoption of the new standards or that is already present at the time of its effective date. Included in the scope of the leases covered by the new model are leases of right-of-use assets in a sublease agreement with specific exceptions provided for leases of intangible assets, exploration or use rights for oil, minerals, etc., and biological assets such as certain agricultural assets.

Significant Items from the Basic Proposal

Lessees and lessors will apply a right-of-use model when accounting for all leases included in the scope of the standard.

Under this approach a lessee would record an asset on its balance sheet representing the intangible right to use the leased asset for the term of the lease and a liability to make lease payments.

The lessor would record an asset on its balance sheet for the right to receive lease payments. Depending on the lessor's exposure to the risks and benefits associated with the underlying asset, it would either record a lease liability while continuing to recognize the leased asset or derecognize rights in the leased asset that have been transferred to the lessee while continuing to recognize a residual asset representing the rights in the asset at the end of the lease term. This derecognition method of accounting for the liability is similar to the current accounting for sales-type leases under U.S. GAAP.

When assets and liabilities are recorded in the financial statements, the lease term will be measured on a basis that assumes the longest possible term that is more likely than not to occur. This is a substantial change from the current lease accounting model which relies on the initial contractual term of the lease and does not consider renewal or extension periods. Additionally, lease payments that are used to calculate the initial value of the asset or liability will include contingent amounts, such as rents based on a percentage of a retailer's sales and rent increases linked to indexes such as CPI.

The new assets and liabilities will be recorded and carried at amortized cost based on the present value of the payments to be made over the term of the lease. Since the lease assets and liabilities will be based on present value, the revenue recorded will change in terms of both its timing and presentation. A portion of the straight-line rental revenue and expense that is currently presented in financial statements will be replaced by interest revenue or expense related to the present value calculations. This interest revenue or expense will be greater in the earlier years (similar to a mortgage) which will cause the total revenue or expense to be front-loaded for the lessor or lessee, respectively.

Finally, the most significant impact of this new proposal for lease accounting is that it will eliminate the current off-balance sheet accounting for assets under operating leases. According to estimates, the new standard could bring approximately $640 billion of leased assets and corresponding liabilities under leases onto corporate balance sheets. Given that this estimate only considered for-profit enterprises, the true total is likely to be significantly higher than the estimate.

For both lessors and lessees, many questions exist regarding the impact of this new accounting standard. It remains to be seen how banks, investors, and other stakeholders will compare, evaluate, and rate the performance of companies and organizations that are required to prepare GAAP-basis financial statements once a new lease accounting model is adopted. The expected changes in the financial position and financial operating results of lessors and lessees may be substantially different than what people know and are comfortable with today.

Given the impact that this proposed change in lease accounting is expected have, lessors and lessees who prepare GAAP-basis financial statements should begin assessing how their financial reporting would be impacted and developing a strategy for dealing with the new standard. Bond Beebe's professionals can assist you with all aspects of your accounting, tax, and advisory service needs including planning for the implementation of new accounting standards. For any questions you may have or further information on this or other tax and accounting matters, contact either Jacqueline Thompson, CPA at thompson@bbcpa.com or at 301-272-6027 or Michael Rockefeller, CPA at rockefeller@bbcpa.com or at 301-272-6006.