Effective accounting for leases has traditionally been managed under a dual model in which leases are classified and reported under two different models. As defined through current accounting standards, a majority of leases are often not reported on a company’s balance sheet. The amounts involved can be significant, as many businesses lease much of their equipment.

The existing accounting models for leases require lessees and lessors to classify their leases as either capital leases or operating leases, and to account for those leases differently. For investor-held companies, these models have been criticized for failing to meet the needs of investors and other users of financial statements because they do not always provide a faithful representation of leasing transactions.

The two leading accounting standards organizations – the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have been working jointly on strategies to improve the clarity and transparency of lease accounting for some time. In 2015, it is expected that both entities will release new rules for how businesses track lease expenses under Generally Accepted Accounting Principles (GAAP).

The proposed new standard, which was released for comments as an exposure draft in 2013-2014 and which is expected to be finalized in late 2015, would require lessees to include all leases, including leases of equipment and other assets, generally classified as operating leases, on the balance sheet.

This will force an enormous number of “off-balance-sheet” leases to be brought onto companies’ books, and it will change the way lease liabilities are calculated.

The reason that many leases are “off-balance-sheet” is because of the historic distinction between an operating lease and a capital lease. For example, if your company leases a Pitney-Bowes postal meter, that is considered an operating lease because you rent the equipment but can never own it. Therefore, the cost of the meter’s lease is treated as current expense. Office space leases are treated the same way.

This is contrasted with capital leases, where you might pay a monthly fee for the lease on a rent-to-own basis with a fixed term, and then end the term with a ‘bargain buy-out’ (like a $1.00 payment) in order to own the equipment in the end. In this case, you are financing a purchase rather than renting assets indefinitely.

Capital leases, therefore, are treated as assets and liabilities on the books. In contrast, operating leases are usually addressed in financial statements with footnotes, where the company may indicate the remaining term of its operating leases since these are legal obligations the company has entered into.

For most real estate leases, a lessee would report a straight-line lease expense in its income statement. However, for most other leases, such as equipment or vehicles, the lessee would depreciate the asset over its useful life and report interest expense on the lease liability over the term of the lease.

Large companies or those with extensive leased assets will follow these new rules because their auditing processes are based upon GAAP principles. In addition, companies that are publicly traded or those who anticipate selling shares in the future will want to follow the rules precisely because the Securities and Exchange Commission (SEC) is expected to adopt them as regulatory requirements.

However, privately held small businesses may elect to make changes depending upon their current and future accounting practices and objectives, including whether or not they operate on a cash or accrual basis and whether or not they anticipate pursuing future transactions (merger, acquisition, strategic sale, public offering) that may trigger or strongly benefit from strict “big GAAP” compliance. It is also not known whether the IRS will apply the changes envisioned in these new standards to rules for business taxes.

To learn more about the anticipated new FASB lease accounting rules and how they might apply to your business or to your tax strategy, consult with your CPA today.

Selected Sources:

5 Ways to Prepare for New Lease Accounting Rules
http://www.accountingweb.com/article/5-ways-prepare-new-lease-accounting-rules/223964

Project Update: Leases—Joint Project of the FASB and the IASB
http://www.fasb.org/jsp/FASB/FASBContent_C/ProjectUpdatePage&cid=900000011123

Between Big GAAP and Little GAAP, There are Many Gaps
http://www.accountingtoday.com/blogs/debits-credits/Between-Big-GAAP-Little-GAAP-Many-Gaps-68176-1.html

Image Credit: Tomi Knuutila (Flickr @ Creative Commons)