Analyzing the implications of the accounting standard update, topic 842

In 2010 the Financial Accounting Standards Board (FASB) made a proposal to modify the current United States Generally Accepted Accounting Principles (US GAAP) rules in regard to leases, summarized in ASC 840. The proposed changes would alter the entire way in which companies reporting in accordance with US GAAP would identify, classify, and report leases, in accordance with the Accounting Standards Update, Topic 842 (ASU 842). The classification of leas es and reporting standards under US GAAP would significantly change if the roposed alterations are accepted. The benefits of the changes would help to improve transparency to company stakeholders, as well as aid the convergence process with the International Financial Reporting Standards (IFRS). In theory the goals of the amendment to lease accounting are good in nature, but the implications of the changes are far reaching. The changes on the value of the companies' financial statements could potentially have detrimental implications on the American economy, and provide for new problems for financial institutions . This thesis will assess the benefits and possible implications of convergence between IFRS and US GAAP in regards to leases.

ANALYZING THE IMPLICATIONS OF THE ACCOUNTING STANDARDS UPDATE, TOPIC 842 by Allison Miaki Uchida A Senior Honors Thesis Submitted to the Faculty of The University of Utah In Partial Fulfillment of the Requirements for the Honors Degree in Bachelor of Science In Accounting Approved: ______________________________ David Plumlee, PhD Thesis Faculty Supervisor ______________________________ Rachel Hayes, PhD Chair, Department of Accounting ______________________________ David Plumlee, PhD Honors Faculty Advisor ______________________________ Sylvia D. Torti, PhD Dean, Honors College May 2016 Copyright © 2016 All Rights Reserved ABSTRACT In 2010 the Financial Accounting Standards Board (FASB) made a proposal to modify the current United States Generally Accepted Accounting Principles (US GAAP) rules in regard to leases, summarized in ASC 840. The proposed changes would alter the entire way in which companies reporting in accordance with US GAAP would identify, classify, and report leases, in accordance with the Accounting Standards Update, Topic 842 (ASU 842). The classification of leases and reporting standards under US GAAP would significantly change if the proposed alterations are accepted. The benefits of the changes would help to improve transparency to company stakeholders, as well as aid the convergence process with the International Financial Reporting Standards (IFRS). In theory the goals of the amendment to lease accounting are good in nature, but the implications of the changes are far reaching. The changes on the value of the companies’ financial statements could potentially have detrimental implications on the American economy, and provide for new problems for financial institutions. This thesis will assess the benefits and possible implications of convergence between IFRS and US GAAP in regards to leases. ii TABLE OF CONTENTS ABSTRACT………………………………………………………………………………ii INTRODUCTION ………….…………………………………………………………….1 OVERVIEW OF PROPOSED CHANGES………………………………………………3 POSTIVE IMPLICATIONS……………………………………………………………...7 NEGATIVE IMPLICATIONS……………………………………………...………...…11 ANALYSIS………………………………………………………………………………16 APPENDICES …………………………………………………………………………..21 REFERENCES ………………………………………………………………………….28 iii INTRODUCTION The FASB has many reasons why they are looking to change the way US companies approach reporting leases. The initial rationale behind ASU 842 arose from the FASB’s desire to begin assimilating with the International Financial Reporting Standards. A large proportion of the world has either adopted the IFRS, or have pledged to do so by an upcoming date (Appendix A). Because of the differences in US GAAP and the IFRS, it creates problems within the business world (Garmong, 2012). Regardless of which country a company operates in, foreign business affairs will likely affect it at some point. This is especially true with the number of American companies looking to merge or acquire non-US companies, or vice versa. Multinational companies come across complex problems when they try to bridge the gap between the two reporting standards. Stakeholders may “require IFRS financial information, audited IFRS financial statements, and budgets and management information prepared under IFRS” either because it is required by law or simply because stakeholders want to be able to see the financial statements from the IFRS perspective before making decisions (Pricewaterhouse Cooper, 2013). The globalization of the US marketplace is making the need for the United States to adjust financial reporting standards incredibly important. Because of the lack of geographical boundaries within businesses and trade, it makes it difficult for companies to deal with the differences between US GAAP and IFRS. The FASB is working towards a more IFRS based set of accounting principles in the US because of how many resources are currently being used to manage the differences. For over a decade the FASB has been 1 pressured by multiple entities, such as the SEC (Securities and Exchange Commission) and the AICPA (American Institute of Certified Public Accountants), to begin making US GAAP more consistent in relation to the international standards. Starting in 2002 both the FASB and IASB have been working together towards something called “convergence.” This process should not to be confused with adoption which is the total acceptance of using IFRS. The FASB has been working with the IASB in order to remove major differences between the two standards (AICPA, 2015). Beginning in 2002, the two boards began to work together in order to remove discrepancies between the international and US standards. This attempt at convergence is to make it easier for companies to deal with foreign subsidiary companies, or international investing. This will help to create more fluidity between domestic and international companies operating under both US GAAP and IFRS. The need for changes in terms of leases is long overdue and is one of the final steps towards convergence (Barker et al, 2016). In addition to making the two forms of reporting more similar, changing the way in which leases are reported under US GAAP will hopefully increase transparency for stakeholders. Many believe that current US GAAP allows for companies to hide a plethora of liabilities, making the financial statements misleading to the readers of them. By making the US GAAP more similar to how IFRS requires leases be recorded, it will increase transparency and allow stakeholders to have a more upfront view of company finances. 2 OVERVIEW OF PROPOSED CHANGES There are many differences between him and IFRS that the proposed amendments would address, and would apply to any publicly traded or not-for-profit company, and later all other entities effective for fiscal years beginning after December 15, 2018 and December 15, 2019, respectively (FASB, 2016). The first is the definition of a lease itself. ASC 840 currently defines a lease as “an agreement conveying the right to use property, plant or equipment, land and/or depreciable assets usually for a stated period of time.” Under ASU 842, each business contract must assess if it contains a lease, and, unlike current standards, will assess all assets. If the contract depends on the use of a clear and identifiable asset, the businesses must assess who has the right to control the use of it. If it is determined that a lease agreement does not exist, companies do not report the contract on the balance sheet. The identification can apply to an entire asset, or only a portion if it deemed that part of an asset (i.e. a area of a building) is controlled by the lessee. Appendix B illustrates the processes companies will use to evaluate whether or not a lease agreement is contained within a contract, making the determination of lease existence critical to the new rules (Barker et al, 2016). Under the new rules, more contracts would likely to be considered to include a lease than under current GAAP, especially since ASC 840 currently only applies to property, plant, and equipment, while the proposed changes will apply to all assets. Since all assets are now taken into consideration in the determination of a lease agreement within a contract, ASU 842 would also assess the economic benefit derived from the leased asset. In order for the lease agreement to be classified on the books of the lessee, they must derive substantially all of the economic benefit from the asset, as well 3 as have right to direct the use of the stated asset. The right to direct the asset essentially evaluates the customer’s ability to change the asset or its outputs (Barker et al, 2016). Because the evaluation is not structured with specific evaluations, this will allow US GAAP more flexibility in determination, a characteristic seen frequently in IFRS. Additionally, the classification of leases will change. ASC 840 currently uses a structured 4 step process (Appendix C) with specifications in order to determine if the lease is a capital or operating lease. Instead of existing classification rules, companies will determine the nature of the leases based on a simplified principle. ASU 842 proposes a two step process for determining what classification the lease should receive from a lessors’ recognition standpoint (Appendix D). The first is determining whether essentially all of the underlying asset’s risks are rewards are transferred to the lessee; if they are, then it is a sales-type lease. If the risks or rewards are not transferred to the lessee, it must then be determined whether the lease is a finance lease (formerly called capital lease in ASC 840), or an operating lease based on whether the risks and rewards of the effective control of the asset are on transferred to the lessee or the lessor (Barker et al, 2016). From the lessor standpoint, not much has changed, however from the lessee perspective the distinction between finance (or “Type A”) leases, and operating (or “Type B”) leases is now much less structured than current ASC rules. Unlike current ASC 840 principles, which uses a very structured standard for classifying lease types (Appendix C), the ASU 842 would propose a classification based more on professional judgment. Under current US GAAP, companies are only required to report the liabilities associated with the leased asset if it is classified as a capital lease, with operating leases reporting no associated liabilities whatsoever. Because of this fact, US GAAP has been 4 criticized for hiding liabilities from stakeholders in companies that hold significant amounts of operating leases. The proposed changes to the standards would reclassify many existing leases as finance lease, and therefore require the liabilities associated with the leased asset to be recognized on the balance sheet, increasing transparency to stakeholders. The FASB supports the IASB idea of transparency to help company stakeholders feel more informed and to give companies less room for manipulation of wealth. The current standards allow for companies to conceal billions of dollars’ worth of debt because they are simply not required to report the information on the financial statements, but rather in small footnotes that are oftentimes overlooked (Bryan, 2015). In addition to reclassifying improperly categorized leases, liabilities that were formerly unreported would be brought onto the balance sheet because the new rules would require both finance and operating leases to record the corresponding liability. If a lease has a term longer than 12 months, the lessee will recognize a right-of-use (ROU) asset, and its corresponding lease liability, initially measured at net present value of the lease payments (FASB, 2016). Because both Type A and Type B now require the corresponding liability to be reported on the balance sheet, the FASB has allowed for some transition relief. Transition Relief refers to the right for an entity to elect not to reassess whether or not an existing or expired contract contains a lease, lease classification on expired leases, and the initial direct costs of an existing lease. It does not, however, forgive the misclassification of formerly misclassified existing leases whose term exceeds the date that ASU 842 will come into effect. Because of this, not only will there be an increase in reported liabilities due to future contracts containing lease, but will also reveal liabilities related to any former lease that was incorrectly 5 classified as an operating lease when it was more similar to a capital lease in nature. Those leases that should previously have been considered a capital lease will have to have its corresponding liability reported on the balance sheet (Barker et al, 2016). If the proposed changes to lease accounting do end up taking place, lessees would recognize the asset and the associated liabilities, representing the obligation to pay, and amortize the payments over the period of the lease. Capitalization and amortization of the expenses would depend on the classification of the lease (Pricewaterhouse Cooper, 2013), resulting in a dual-method under FASB, as opposed to the IFRS single-method. Type A leases would use a front-loaded recognition technique, while Type B leases would use straight line, which would account for the typical amounts of time that the leases are to be on a company's books. Because Type A leases are typically on the books for most of the asset’s economic life, the FASB is pushing for more recognition of the asset in the beginning of its life in order to reflect the way that Type A assets consume most of their useful life in the first few years of their use. Essentially Type A leases will be structured as a purchase of an asset using financing (Cossio et al, 2015). Contrastingly, Type B assets, such as land, rarely lose their value rapidly and therefore would be expensed on a straight-line basis; in other words, companies would recognize the same amount of income or expense each period because of the fact that Type B leases will probably not lose value by the end of the lease term (Barker et al, 2016). 6 POSITIVE IMPLICATIONS The advantages to the proposed GAAP changes arise from major problems that currently exist within financial reporting. The first is international feasibility. Even within the US market, it is impossible to say that there aren’t international factors that affect US companies, transactions, and other business affairs. Due to the current differences between US GAAP and IFRS, there is disparity on many levels between US and international companies. Difficulties arise for companies who are investing when they try to determine the feasibility between the two financial statements. Because of the differences in US and international reporting, net incomes, assets, and liabilities determined under one of the forms of reporting may result in a different amount under the alternative reporting standard. This discrepancy is the reason the FASB and the IASB have decided to converge the two standards of financial reporting (Cossio Et Al, 2015). The reclassification of leases and the manner in which leases are reported on the financial statements would be a major solution to a problem that has created a disjointedness with reporting under the two different standards. The proposed changes to the way in which leases are reported will help to bridge the gap between the way that the IASB and the FASB report their financial statements (Cossio Et Al, 2015). Many American entities, including the AICPA and the SEC, have been in favor of the ASU 842 because of the fact that the proposed alterations to reporting leases would ease the cohesiveness between domestic and international companies. Not only does it make it difficult for companies to compare financial statements, but it also has become burdensome to have to convert financial statements to the alternate form of accounting standards. Currently, the differences in valuation, presentation, and other aspects of US 7 GAAP and IFRS take both time and resources to convert the financial statement and make them compatible, or even comparable, by companies (Bramwell, 2014). Convergence between US GAAP and IFRS is favorable because stakeholders ranging from the average investor to companies seeking to purchasing foreign subsidiaries are currently having to reconcile the differences between the two standards. Parent companies reporting a foreign subsidiary’s financial information can have difficulty if the two are reporting under different standards (Garmong, 2012). Not only does it complicate the acquisition of foreign entities, but it also can become convoluted when the parent company is consolidating subsidiary financials for their 10-K. Parent companies with publically traded stock in the American market are required to report their consolidated financial statements of all in accordance with US GAAP. In many cases, if the subsidiaries exist in the foreign market, they are required to report income and their financial statements under IFRS. This discrepancy between the ways in which the two companies report can not only take time and resources to convert, but can also become subjective when the financials are being translated between the two reporting standards (Cossio Et Al). The modifications that ASU 842 would bring to financial reporting are also being praised for the consistency that will arise for economically similar transactions. Since any asset will be assessed and more contract agreements will be considered to be a lease. Previously, there was some ambiguity between what could be considered a lease and a service contract. This benefits companies that are currently reporting leases while other companies are considering similar transactions to be a service agreement that does not require the same extent of disclosure. ASU 842’s decrease is specificity will allow for 8 leases to be classified based more on the nature of lease, and will result in less inconsistencies within all reporting and make companies more easily comparable (Capdevila et al., 2015). Debatably the most important reasoning behind ASU 842 is transparency to stakeholders. As the current ASC 840 stands, the classification for capital leases is so specific that many companies will specifically structure contracts so the leases will fall in the operating lease category, when really the leased agreement is more of a capital lease in nature, and falls barely short of the specifications. American standards allow companies to hide a substantial portion of their lease related liabilities from their financial statements because leases are incorrectly categorized as operating leases, therefore leaving their associated liabilities off the balance sheet (Garmong, 2012). This standard of reporting has been criticized for the past few years because of the somewhat manipulative way companies can portray their financial statements to stakeholders. Critics argue that the ability under the current standards to hide company liabilities can be misleading to investors, and do not appropriately portray the debt the companies hold. Companies who are classifying essentially capital leases as an operating lease make it appear as if their debt to equity ratio is lower than it actually should be, a fact that is can be incredibly misleading depending on the amount of operating leases that have been misclassified. The FASB emphasized the inclusion of liabilities on the balance sheet in order to achieve a higher level of transparency to stakeholders, and to discourage companies from being able to manipulate their financial statements (Garmong, 2012). ASU 842 lacks specificity, meaning that companies can no longer structure contracts to achieve the capital lease status, and therefore excluding liabilities that they 9 actually hold. Approximately $2 trillion worth of lease related liabilities are anticipated to be reclassified as finance leases, and become disclosed on the balance sheet (Rapoport, 2015). In addition to the reclassification of formerly disguised lease agreements, the reporting of liabilities related to both finance and operating lease will drastically increase the transparency of the financial statements, a quality that many people believe is more corporately responsible. This information is crucial not only to investors, but to lenders and other stakeholders as well. The increase in transparency could be monumentally beneficial to all stakeholders interested in companies that are holding leases that are currently held off balance sheet. The current problem with ASC 840 can be seen by Appendix F. Apple reports their liabilities in item 6 of their 10-K, in their selected financial data. However, an investor would have to go to item 7, a footnote and disclosure portion of the 10-K, in order to realize the $6.3 billion worth of leases that remain off balance sheet. Though it is disclosed in the financial statements, it isn’t included in the balance sheet, meaning it will also not affect financial calculations, ratios, and other indicators of financial health. 10 NEGATIVE IMPLICATIONS Despite the positive intentions of ASU 842, there are serious negative implications that will come from accepting the update as it stands. One major issue that is seen by many is the cost of the new update. The amount of time and resources that will need to be spent in order to have companies, accounting firms, and other financial entities fully understand the new update and know how to comply with it is potentially overwhelming. Current standards are drastically different, and even individuals who are knowledgeable about the IFRS manner of reporting leases would not know how to account using ASU 842 because of the dual-method which proposes different methods for Type A and Type B leases. Training will be costly for anyone regardless of their previous knowledge of US GAAP and IFRS, alike. World-wide educating for both finance and non-finance personnel alike would be required initially and sustained thereafter. Information technology systems would likely need to be updated, or possibly even redeveloped in order to accommodate the new methods of accounting for leases; a task that could potentially cost thousands of dollars for any given entity. In addition, the updates would create a need for the development of new internal controls and monitoring systems. The new update cumulatively has a high cost associated with its adoption by any entity to be able to implement and sustain it (Cangialosi, 2013). Another concern people have had with ASU 842 is the manner in which leases are amortized during their lease term. The new update would require companies to use the dual-method of accounting, whereas IFRS has a single approach method for expensing leases, where all leases are classified as if they were operating leases, and expensed using the straight-line method (Bramwell, 2016). Many believe that this single method allows 11 for more consistency and makes reporting easier for companies. Others are concerned that under ASU 842 too many leases will be classified as capital leases, causing the leases to be expensed more up front, and therefore making the lease expense heavy at the beginning while others are proportionately expensed if they are Type B leases. Because of this problem, the recognition of the asset may be sped up too rapidly and result in skewed data on the financial statements. This would create volatility for the financial statements, with large impacts in the first years of the lease, and too minimalist of an impact in later years (Pricewaterhouse Cooper, 2013). Critics of ASU 842 are concerned about the differences and how it will affect a variety of businesses depending on how they are classifying their leases. The most criticized area of the proposed changes is by far the recognition the liabilities associated with the leases. Most are not concerned with the increase in transparency, but rather are unsettled by the possible implication that the sudden influx of liabilities could cause to the American economy. Many speculate that the results will be astronomically detrimental within the years following the adoption of ASU 842. In fact, Loretta V. Cangialosi, Senior Vice President and Controller of Pfizer Inc., believes that the costs of adopting ASU 842 will greatly outweigh the benefits that could possibly come with the update. Cangialosi points out that many investors do not understand that typical companies lease assets to help with general administrative activities, as opposed to assets that are directly tied to the revenues of the company. She argues that the update uses a “one size fits all” approach for reporting leases and that many investors do not have the knowledge to separate the nature of the influx of liabilities. What Cangialsoi believes many will not understand is that many leases are long-term agreements that are 12 not a critical part of understanding the operations of the business, however under ASU 842 they would be required to be brought onto the balance sheet, appearing to investors that the company is in a worse financial position when in reality they are not (Cangialosi, 2013). When it comes to implementing ASU 842, debt covenants are also something that must be considered. Oftentimes, lenders will require their borrowers to remain under a certain level of debt in order to keep their loans. Some critics are concerned that lenders will not know how to restructure the debt covenants in a way that will accommodate for the influx of liabilities from leases that the companies already have in place. Others believe that lenders will simply consider it a violation of the debt covenants and therefore make adverse decisions (Burkholder, 2016). Regardless of the reaction, companies are not the only ones who will have to reevaluate the methods used in regards to reporting debt. Banks and other lenders will have to assess the levels of debt and modify covenants. This may sound like a simple task, however since different companies have varying amounts of debt, it could quickly become a convoluted process. According to Pricewaterhouse Cooper, the amount of assets is overwhelmed by the amount of unreported liabilities associated with operating leases and the inclusion of these liabilities on the financial statements would completely change the value of the companies. Accounting ratios are often times used to make financial decisions, whether it be lenders, investors, or other stakeholders. The issue is not so much that the company has any more debt than they previously held, but since it will be included on the balance sheet it will appear as if that is the case, and the liabilities may seem overwhelming to stakeholders, when in reality the leases are not a major burden to companies (Chang & 13 Adams Consulting, 2012). The increase in reported liabilities may seem indicative of a sign of financial distress in the view of some stakeholders, even if the company is capable of handling the associated liabilities. High debt to equity ratios can be detrimental to companies due to the misleading nature to investors. Many investors and stakeholders are deterred by high debt to equity ratios because it typically is indicative of high risk and a lower likelihood for shareholders to see high dividends. Additionally, this ratio immediately deters lenders because of their concern for apparent inability to repay loans (Investopedia). Not only do the proposed changes allow for financial statements, additionally the effects outside of intercompany matters could be detrimental. This change will not only affect the individual companies and their respective investors, but it also has the potential to affect the entire US economy in a negative way. History has proven that America has an incredibly reactionary economy. For instance, the bank crisis in the 1930’s; though there was an initial problem with the banking system, it was magnified drastically by the reaction of the public, who withdrew their funds from the banks, causing them to fail. The increase in liabilities on so many major US companies, indicating a high-risk borrower would likely increase interest rates for companies affected by ASU 842. In turn, interest rates would impact the overall economy and would increase interest rates to even the average American borrower. In 2012 Change & Adams Consulting, on behalf of the US Chamber of Commerce, studied effects that ASU 842 would likely have on the American economy based on previous economic trends. Their research found that it is likely that the less favorable accounting ratios would lead to a decrease in corporate spending. Additionally, jobs would most likely be affected in order to decrease company 14 liabilities. Their findings approximated that under the best case scenario, jobs in America would be reduced by 190,000, however, worst case scenario would result in a loss of 3.3 million jobs (Chang & Adams Consulting, 2012). By combining basis points that took into account the change in interest rates, decrease in gross domestic product, loss of jobs, and other economic factors, and calculated the overall fiscal impact on the economy if ASU 842 were to be implemented in 2015 (the original date of implementation before it was extended by the FASB). The results were staggering (Appendix G). Within 6 years following implementation of ASU 842, the cumulative fiscal impact of the inclusion of lease-related liabilities resulted in a worst case scenario of $1.1 trillion. Under ideal conditions, it was predicted that economic factors considered would in a less drastic, but still concerning $37.7 billion (Chang & Adams Consulting, 2012). As previously stated this takes into consideration the reactionary impacts of the general public and corporate decisions that have proven to cause more damage in the past. The result of something as simple as reporting leaserelated liabilities on the balance sheet has the potential to create detrimental effects on the US economy. 15 ANALYSIS Not only are companies and other financial institutions concerned about the ramifications, but even voting members of the FASB are not in consensus of ASU 842. Marc Siegal, longtime member of the FASB board, argues the inclusion and valuation of the leases will not be helpful to users. The other six members of the board have affirmed it, which is an increase from the last vote where only two had been in favor of the update, however Siegal shows no signs of letting the issue rest. He believes that extraordinary changes still need to be made in order to deem the update to be helpful to users of the financial statements (Cohn, 2016). Siegal is far from the only critic of ASU 842, however the FASB has listened to issues that have been presented to them and have already issued updated versions in order to fix them. With former problems being resolved already, it is likely the FASB will have to do something in response to the drastic increase in liabilities. Although the rationale behind transparency to company stakeholders is to charge companies with a higher amount of responsibility and honesty, the larger question lies with whether the economic implications of including the unreported liabilities are worth said transparency. On one hand, there is an obvious value in honesty to the general public. Current standards beg the question of whether it ethical to allow companies to continue nor reporting the overwhelming amount of leases. Were there to be no economic implications, it would be hard to argue against mandating the reporting of all assets and liabilities relating to operating leases. However, as it stands, the sudden introduction of the liabilities has potentially serious effects on the American economy. 16 It is difficult to assess whether ASU 842 is beneficial to the economy, because as it stands it is a double edged sword. The transparency that the will come with the requirement for companies to include operating lease liabilities may come with staggering economic implications, however, allowing companies to continue excluding billions of dollars’ worth of liabilities from their balance sheet can be incredibly misleading to stakeholders. Though the increase in transparency is to attempt to become more ethical towards those who rely on the financial statements, it becomes questionable whether the increased disclosure is, in fact, ethical given the potential implications. Looking to the future, there are many ways to speculate how the proposed changes will affect the American economy. Research conducted by the Chang & Adams consulting speculates that anywhere from $1 trillion to $2 trillion worth of liabilities would be required to be reported due to the change in standard for reporting operating leases (Chang & Adams Consulting, 2012). If the increase in liabilities creates a decrease in spending by millions of companies, the effects on the rest of the US economy could be severe. The loss of jobs in America, increase interest rate, and other negative implications associated with the update, has the potential to be detrimental to the economic health of America (Chang & Adams Consulting, 2012). In order to peacefully adopt ASU 842, there must be a way to remedy the two. Transparency should always be a goal from companies, however there must be a way to introduce it without stifling corporate spending. Though the FASB is attempting to increase transparency to company stakeholders, it appears as though the effects of the changes in lease accounting have the potential to cause devastating consequences to the American economy. That being said, 17 the United States must find a way to remedy the conflict of not having a manner of reporting leases with transparency, with the potentially detrimental effects of adding associated liabilities to company balance sheets. It is hard to believe that the FASB will back down from the currently proposed changes, due to the benefits that come with convergence with international standards. It can be foreseen that the drastic increase in liabilities will have a negative effect on the US economy, however, how America will deal with it is perhaps the bigger question. That being said, the US will have to figure out how to adapt to the new changes. Currently the standard has “Transition Relief,” for companies, however it is an overall ineffective gesture. It allows for all previously expired or pre-existing leases to be exempt from the new rules, as well as exclude all initial direct costs for setting up leases. The problem with the transition relief as it stands is that it does not apply to previously misclassified leases. Since there has been a large issue with current ASC 840 classifying leases as operating lease due to specifically structured contracts, the update would likely reclassify billions of dollars’ worth of leases and therefore bring their associated liabilities onto the balance sheet (Barker et al, 2016). One way to remedy the situation would be for companies to be proactively reclassifying their leases. Though ASU 842 is required to be adopted by 2019, companies may choose to apply the changes to their lease accounting immediately. This would allow for a slower introduction of liabilities and reduce the dramatic shock that would come to the economy with the sudden introduction of all liabilities associated with leases. Introducing the liabilities on a scaled basis would allow for companies to have time to adjust to the changes in standards. It would decrease the amount that the debt to equity ratios would rise by and also allow for 18 more transparency. Although the companies would still need to be flexible, and able to adjust to the increase in liabilities, the staggering of the introduction of them would hopefully lessen the impact that it would have on the American economy. Unfortunately, it is unlikely that companies will proactively begin applying standards. Another way to help compromise the situation is for the FASB to allow for greater transition relief. If companies holding large amounts of operating leases were allowed to recognize liabilities on a percentage basis, slowly introducing previously held liabilities associated with their operating leases, perhaps it would lessen the negative effects of the inclusion. As years continue, a higher percentage of the liabilities would be reported over a span of time, allowing for the transparency stakeholders want, while also giving companies more time to adjust to the changes. Another idea brought to light by the SEC would be to allow for companies to continue using US GAAP for reporting purposes, but have the footnotes and disclosures of the financial statements be in accordance with IFRS. This way, it would be a way to converge the different reporting standards while not completely changing the reporting for US companies (Katz, 2016). This does seem to be a way to allow for more internationally feasibility, however, it does not solve the issue of transparency. A majority of leases would still remain off the balance sheet and only be seen in the footnotes, which is the issue the FASB was attempting to fix. Despite the FASB’s good intentions, there are many factors within the proposed changes to lease accounting that they must investigate. There is value to converging with the international standards, however with the current proposal it would be at the stake of the health of the American economy. In order to provide for stability, the FASB must 19 continue to reevaluate their proposal, and remedy their drive for convergence with the nature of the US economy. By evaluating and reissuing ASU 842 with a new transition relief to better aid in the adoption of the new standards, the FASB can help to address the massive backlash that has been voiced by virtually every US company, while still allowing for the transparency stakeholders and governing bodies are in favor of. Until the FASB makes major changes to their proposal, they are a long way from achieving both convergence and success. 20 Appendix A Map of World-Wide IFRS Compliance 21 Appendix B 22 Appendix C Current Evaluation of Operating Leases vs. Capital Leases a. Capital Lease: i. Substantial risks and rewards pertaining to the leased asset transfer from the lessor to the lessee. b. Operating Lease: i. Negligible risks and rewards pertaining to the leased asset do not transfer from the lessor to the lessee. ii. Comparable to a rental agreement. Under FASB ASC 840-10-25-1 if a lease satisfies any of the following four criteria, the lease agreement will be considered a capital lease. 1. Does ownership transfer from the lessor to the lessee? 2. Does the lease offer a bargain purchase option? 3. Is the lease term at least 75% of the leased item’s economic life? 4. Is the present value of the minimum lease payments at least 90% of the fair value of the leased property? 23 Appendix D Classification of leases by a lessor in accordance with ASU, Topic 842 24 APPENDIX E Recognition of Leases in accordance with ASU, Topic 842 For finance leases, a lessee is required to do the following: 1. Recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments, in the statement of financial position 2. Recognize interest on the lease liability separately from amortization of the right-of-use asset in the statement of comprehensive income 3. Classify repayments of the principal portion of the lease liability within financing activities and payments of interest on the lease liability and variable lease payments within operating activities in the statement of cash flows. For operating leases, a lessee is required to do the following: 1. Recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments, in the statement of financial position 2. Recognize a single lease cost, calculated so that the cost of the lease is allocated over the lease term on a generally straight-line basis 3. Classify all cash payments within operating activities in the statement of cash flows. 25 APPENDIX F Apple Inc. 2015 10-K; Item 6 Apple Inc. 2015 10-K; Item 7 26 APPENDIX G 27 Bibliography Apple Inc. (2015). ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (Rep.). Barker, J., Farber, T., McKinney, S., & Kolber, T. (2016). Bring It On! FASB’s New Standard Brings Most Leases Onto the Balance Sheet. Heads Up, 23(5). Berkowitz, A., & Rampell, R. (2002, December 2). The Accounting Debate: Principles vs. Rules. Retrieved from http://www.wsj.com/articles/SB103886213539574553 Bishop, J., & Paul, B. (2013, October). Lease Accounting. Point of View. Bramwell, J. (2014, June 24). Joint Accounting Rule on Leases May Not Happen in 2014. Accounting Web. Retrieved from <http://www.accountingweb.com/article/joint-accounting-rule-leases-may-nothappen-2014/223533>. Bramwell, J. (2016, February 25). The Wait is Over: FASB Issues New Guidance on Lease Accounting. 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