During its 2014 meetings to date, the Financial Accounting Standards Board (FASB) made significant revisions to the lease accounting changes they had proposed in their 2013 Exposure Draft, Leases (Topic 842). Grassi & Co. and others had made strong arguments against the Exposure Draft proposals in comment letters, and believe that the FASB’s 2014 revisions will reduce the complexity of the originally proposed rules.
Under current generally accepted accounting principles (GAAP) a lease is classified as a capital lease if it covers such a significant portion of the leased asset’s fair value or remaining economic life that it is equivalent to an asset purchase with secured financing. Capital leases require the asset to be recognized and depreciated on the lessee’s books, with monthly payments amortizing the offsetting liability into principal and interest expense. Leases that do meet the qualifying conditions to be capital leases are considered operating leases and are not recorded on the balance sheet. Rent expense is recognized on operating leases as payments are made.
The main goal of the FASB’s proposed changes is to bring most operating leases onto the lessee’s balance sheet by recognizing a right-of-use (ROU) asset and a lease liability. However, the FASB’s Exposure Draft would have introduced a multi-step model that classified leases based on whether the asset was property or non-property, but with rebuttable presumptions that would require a complex decision tree matrix to implement. The methodology not only would have been costly for companies to execute and track, but would also have been difficult for financial statement users to compare across companies. Grassi & Co. did not see the advantage in classifying leases based on whether or not the underlying asset is property, and stated in its comment letter that a simpler model that evaluated leases based on whether they conveyed a significant portion of the total economic life or fair value is preferred. 
The FASB now has abandoned its multi-step model in favor of a methodology that is closer to current lease accounting. Under the revised rules, most leases currently considered capital leases will be known as a Type A leases, while most leases that are categorized currently as operating leases will be known as Type B leases.
An ROU asset and a lease liability will be recognized for both Type A and Type B leases. However, in Type A leases the ROU asset will be amortized separately from interest expense related to the lease liability, while in Type B leases there will be a single total lease expense. A significant distinction from current accounting for capital leases is that the asset recognized will be an ROU asset rather than the leased equipment or property itself. The main difference from current accounting for operating leases is that the lease will be on the balance sheet rather than just disclosed in the footnotes.
Other decisions on lease accounting reached at the FASB’s 2014 meetings include the following:
- When determining lease term, a company should consider all relevant factors that create an economic incentive to exercise an option to extend or renew a lease, and include the option period if it is reasonably certain that the lessee will exercise the option.
- When determining lease term, a purchase option should be evaluated in the same manner as a renewal option.
- A company may elect to scope out short-term leases of 12 months or less, and treat those similar to current accounting for operating leases by not recording them on the balance sheet. The lease payments would be expensed as incurred and disclosed in the footnotes.
- Initial direct costs should be included in the measurement of the ROU asset and amortized over the lease term, and should include only incremental costs.
- Type A assets and liabilities should be reported separately from Type B assets and liabilities, either on the face of the balance sheet or in the footnotes.
The FASB will continue discussions on various aspects of the rules throughout 2014. A final standard will not be issued before 2015, and the effective date may not come until 2017 or 2018. However, companies should not wait until the effective date to consider the effects on their businesses. The proposed changes to the amounts recorded on the balance sheet as well as the amounts and characterization of expenses may affect calculations in debt covenants, profit sharing and compensation arrangements. Management should consider the potential effects of the new rules when negotiating long-term debt and compensation arrangements going forward. Perhaps debt covenants could be based on current U.S. GAAP, or else negotiated at a level that contemplates the proposed accounting changes.
Grassi & Co. will continue to provide updates on new developments to help companies consider the potential changes when negotiating terms in future agreements.
 Grassi’s letter can be read in its entirety by clicking here.