Proposed Lease Accounting ChangesAugust 29, 2011
The Financial Accounting Standards Board has proposed making significant changes to the way in which companies account for leasing transactions under Generally Accepted Accounting Principles (GAAP). The proposed standard applies to all leases of more than one year; i.e. everything from your copier lease to the lease of your facilities. The proposed standard will have a significant impact on the financial statements of automobile dealers. The proposed standard will effectively result in no amounts being recorded as Rent, Equipment Rent or similar. The present value of lease obligations will be recorded as a right to use asset and lease liability (see examples). The asset will be amortized over the length of the lease and the liability will be reduced as payments are made. A component of the monthly payment will be charged to interest expense.
For the purpose of this article our focus will be on real estate leases, however the reader should be mindful that the standard applies to all leases.
As dealers begin recording leases as assets and liabilities on their balance sheets they should be concerned with several issues. For dealers with better credit ratings, the implicit interest rate used to calculate the present value of their lease obligation will result in larger assets and liabilities being recorded on the dealerships balance sheets. A dealership that is less credit worthy will have a higher implicit interest rate and therefore a smaller asset and liability to record on their balance sheets. Thus, two dealers may each rent a building under a 15 year lease at $20,000 per month, triple net. Dealer A, whose implicit borrowing rate is 4% and Dealer B, whose implicit borrowing rate is 7% will record different asset and liability amounts. Dealer A records a liability of $2,703,843 and Dealer B records a liability of $2,225,119. At the bottom of the provided examples you will see the dramatically different debt to equity ratios that result from the implementation of this standard and the differing current ratios between the example dealers.
If the bank required the current ratio to exceed 1.2, in this example both Dealers A and B meet this threshold prior to implementation of the proposed standard. However, after the proposed standard has been implemented only Dealer B satisfies the ratio. In both situations the debt to equity ratios change dramatically once the proposed standard is implemented. In both situations dealers risk being unable to comply with financial covenants once implementing the proposed standard.
Once these transactions are recorded dealers must consider the impact of these transactions on the following:
- Manufacturer working capital guidelines and other financial guidelines
- Financial covenants with banks, particularly on leverage ratios, as the transactions will indicate a much higher leveraged company
- Will all dealers follow GAAP and record these transactions under the new standard? If not, 20 Group and other industry data may not be comparable.
Currently an implementation date for the proposed standard is not known. Dealers should consider discussing the proposed standard with lenders to develop an understanding of how the proposed standard will impact ratios and other financial metrix. Dealers also should be seeking guidance from their respective manufacturer regarding the implementation of the proposed standard.