GAAP Matters! Do you know where your debt covenants are?

New GAAP standard might impact covenants…are you ready?

GAAP are the rules companies are supposed to use when preparing their financial reports. Although leasing is a fundamental concept that one might think would have been ironed out by the accounting rule-makers years ago – it wasn’t.  I recall being introduced to leasing in my first accounting class as an example where accounting recognizes “substance over form”.

Under this new GAAP rule considerably more leased property will appear on balance sheets…and bring with it considerably more lease liabilities.  Consequently any company with restrictive covenants that are affected by these issues might find themselves with compliance issues.

man in yellow safety vest climbing on ladder
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But first…Lease Accounting – A History Lesson!

In fact, long before my first accounting class, accounting rule-makers have been grappling over the substance over form issue concerning with leases at least since the 1940s!

Perhaps it will only be accounting historians who will remember that Accounting Research Bulletin Number 39 issued in 1949 stated:

 A lease arrangement is sometimes, in substance, no more than an installment purchase of the property.” – ARB 39 (1949)

“A lease arrangement is sometimes, in substance, no more than an installment purchase of the property.

This was further confirmed in 1953 when Accounting Research Bulletin 53 stated that “the committee (Committee on Accounting Procedure – an early predecessor to the FASB) is of the opinion that the facts relating to all such leases should be carefully considered and that, where it is clearly evident that the transaction involved is in substance a purchase, the “leased” property should be included among the assets of the lessee with suitable accounting for the corresponding liabilities and for the related charges in the income statement…”

The Committee on Accounting Procedure was replaced by the Accounting Principles Board (APB), a senior technical committee of the American Institute of Certified Public Accounting. The APB had the primary role of establishing GAAP prior to the formation of the FASB. In 1964 APB Opinion Number 5 reached a similar conclusion concerning leases:

On the other hand, some lease agreements are essentially equivalent to installment purchases of property. In such cases, the substance of the arrangement, rather than its legal form, should determine the accounting treatment.”     APB Opinion 5 (1964)

The attributes described in APB 5, which gave rise to the capitalization, were fairly narrow and were ultimately replaced by the FASB in its early days with FASB Statement 13 and its 4 specific tests covering various conditions which the FASB considered triggered accounting recognition of the leased asset as a capital assets.  Conceptually the four tests developed by the FASB were somewhat straightforward – but accounting firms, regulators and financial statement preparers found issues which spawned dozens of additional FASB statements, interpretation and other technical documents.

In 2016 the FASB issued ASC 2016-02 (ASC) which some say will simplify the lease capitalization issue considerably by requiring a lessee to recognize assets and liabilities for essentially all leases with lease terms of more than 12 months.

Under the new guidance, a lessee will be required to recognize assets and liabilities for leases with lease terms of more than 12 months    FASB 2016-02

So there you have it – essentially all leases of one year or greater will result in asset and liability recognition.

As you might have suspected there is more to than that.  The FASB described that consistent with current GAAP, the recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee primarily will depend on its classification as a finance or operating lease. However, unlike current GAAP—which requires only capital leases to be recognized on the balance sheet—the new standard will require both types of leases to be recognized on the balance sheet.

So, the big difference?   The accounting standard setters old approach required that the lease arrangement transfer substantially all the economic risks and rewards of the leased property to the lessee should rule the day –  the new approach is that all leases of more than 12 months convey an asset to the lessee and that asset (and related liability) should be placed on the balance sheet. One of the more problematic issues with the old rule was determining if the underlying lease transferred enough risks and rewards:

no more

It now appears that the twelve month rule will simplify the balance sheet on/off switch aspect.  For example, should a lessee enter into a two-year lease of an asset with a useful life of say 40 years, the accounting standard setters have reasoned that it has an asset – albeit one with just a  two year life.  The preparer will still need to deal with the issues of qualification and financial statement classification.

The ASU on leases will take effect for public companies for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. For all other organizations, the ASU on leases will take effect for fiscal years beginning after December 15, 2019, and for interim periods within fiscal years beginning after December 15, 2020.

Restrictive covenant compliance issues?

One of the consequences cited by respondents to this standard when it was in the proposal stage is that many companies have entered into debt agreements or other contracts with restrictive covenants…and that some of those covenants limit the amount of debt it can have…or even if it may have a capital lease on its balance sheet.  Consequently companies should evaluate their existing restrictive covenants and determine if implementing this new lease GAAP standard will affect them.

So is substance over form no longer a GAAP accounting concept?  Yes it is but the FASB prefers the term “faithful representation”. Faithful representation means that financial information represents the substance of an economic phenomenon rather than merely representing its legal form.

The new rule on accounting for leases has been known for a long time – what seemed like a far away implementation date is now less than two accounting quarters away.  But even with this long lead time…will all companies be ready?

Andrew M. Mintzer, CPA is a forensic accounting with the Los Angeles office of Hemming Morse, LLP.  He is a past chair of the California Society of Certified Public Accountants.

 

 

 

 

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