Accounting for leases may be complicated by the proposed changes that by FASB and IASB. These two independent bodies aim at altering lease accounting in a view to improve the accounting treatment of leases. The two bodies, which are responsible for setting, accounting standards have the proposed changes in the exposure draft. However, the changes are poised to have certain complications as far as lease accounting is concerned. The complications are expected to impact the business world currently and in the future (Bosco, 2011).
Complication on renewal option
The proposed changes involve a subjective judgment on the lease term. The management must consider any potential renewal options that the lease carries. Such considerations will lead to uncertainty in lease reporting since such terms involve a lot of negotiations. This contrasts to the current rules. Under the current rules, the minimum lease payments are applied in calculating the present value of the lease. This amount is recorded in the balance sheet. An example is a company has entered into a five year asset lease with a 2 year renewal option. The management would have to recognize the asset and associated liability for 7 years if there were a likelihood of renewal. This is controversial since such a company will recognize leases that it is not contractually obliged to accept.
Complication on contingent rent
Payments for leases may be made via contingent rents as stipulated in the lease contracts. The contingent rent is usually tied to sales or consumer price index. Such contingencies are to be recognized in the particular company's balance sheet under the proposed changes. If payments are tied to the sales, a prediction of sales is required for the company to obtain a prediction of payments. This prediction will involve complexity that may outweigh the potential benefit from the changes (Leone, 2010).
Complication on adjustment costs
The proposed changes call for both lessees and lessors to recognize the leased assets and resultant liabilities in the balance sheet. In other words, the changes will eliminate operating leases effectively. Both lessors and lessees will have to use the right of use accounting model (Yadlapati, 2011). This is a shift from the current accounting standards which allow for treatment of leases as routine business operating expenses. In fact, there is an estimated $ 1.3 trillion of leased assets which will go back to the balance sheet. The proposed changes will affect more than a thousand companies around the world thus increasing adjustment costs.
Impact on borrowing capability
The proposed changes will result in an increased balance sheet size they are ratified. This will mainly affect the businesses in commercial real estate leasing. The recognition of the lease liability will result in an increase in debt to equity ratio. It is expected that borrowing will be difficult as a result of the high debt to equity ratio.
Another dimension to the borrowing constraint is that compliance with debt covenants will be quite tough. Usually, the debt covenants prohibit borrowing by a business if the debt will be more than the worth of the business. Capitalization of the assets which have been leased will result in more debts than assets for the affected businesses. This may also result in the revoking of some of the loans hence crippling such organizations financially.
Bosco, B. (2011). FASB & IASB Hold First Meetings on Lease Accounting Project. Monitor Daily , 8.
Leone, M. (2010). Leases Headed for the Balance Sheet. Today in Finance , 1-3.
Yadlapati, V. (2011). Impact of Proposed Lease Accounting Changes . Journal of Accounting and Finance , 3.