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Lease Accounting Changes are Coming

The way we go about accounting for leases will never be the same. On August 17, 2010, the Financial Accounting Standards Board (FASB) published for public comment a proposal that is expected to make significant changes to the financial reporting of lease contracts. The FASB passed this proposal unanimously and the change is considered part of the ongoing convergence between accounting principles generally accepted in the United States (GAAP USA) and international standards set forth by the International Accounting Standards Board (IASB).

While the change is all but inevitable, it has not yet been adopted and the FASB does not expect to do so until the second quarter of 2011. This means that private companies with December year-ends would not see a change to their annual financial statements until December 31, 2012. It is important to note that pre-existing leases will not be grandfathered in and are expected to be subject to a simplified retrospective approach in applying the proposed standard. Furthermore, it is important to note that a few specific types of leases are currently carved out of the proposed standard, including leases of intangible assets, leases of biological assets, and leases to explore for or use minerals, oil, natural gas, and similar nonregenerative resources. Naturally, the vast majority of lease contracts (e.g., buildings and equipment) that manufacturing and distribution organizations enter into will be affected.

Some have described the proposed standard as “the end of leases as we know them.” That’s probably a fair statement as the concept of a capital lease versus an operating lease will disappear for financial reporting purposes (tax rules regarding leases remain unchanged for now). Management teams will have to apply a right-to-use model in the future. Lessees will recognize an asset representing the right to use the leased asset for the lease term and a corresponding liability for the present value of lease payments. The asset will be amortized over the shorter of the expected lease term or the estimated useful life of the asset, and interest expense will be recognized on the liability associated with lease payments. When compared with the current approach used to account for operating leases, the proposed model will result in rent expense being replaced with amortization and interest expense and the likelihood that expenses in the early years of a lease will be higher than those in later years. Given that rent expense is being replaced with amortization and interest expense, this will affect a variety of financial metrics including operating income and earnings before interest, taxes, depreciation, and amortization (EBITDA). It is important to realize that accounting, rather than events in the marketplace, will trigger changes in such financial metrics. This may require that management teams start having discussions with a variety of stakeholders.

While financial statements will change, total cash flows and the substance of an organization will not. Leased assets will no longer be included in the property, plant, and equipment line item of a balance sheet as we have always done with capital leases. In certain cases, an organization may wish to renegotiate matters like debt covenants with its bank due to the change in presentation. How an organization accounts for leases may have nothing to do with its ability to service debt.

Like most significant changes in accounting, this matter is not without complexity and will require judgment on behalf of management teams. For example, the right to use assets referenced above and the related lease liabilities will be measured on a basis that assumes the longest possible lease term that is more likely than not to occur. The phase “more likely than not to occur” is one clear indication that organizations will need to make some judgments in applying the proposed standard for leases. Estimates must be made with regard to renewal periods and other matters. This may require that a management team develop probabilities on the basis of contractual factors, the existence of leasehold improvements, and past history of renewals.

At times, certain re-measurements will also be required during the lease term in order to adjust estimates made at the beginning of the term to actual results.

Many organizations enter into leases with terms of 12 months or fewer. In such situations, a simplified application can be used that ignores the effect of interest in recognizing assets and liabilities.

In summary, any organization with leases has a significant change coming. The future probably looks something like this:

• Proposed rules will eliminate operating lease accounting by lessees, which will result in a variety of changes including the following:
  • Assets and liabilities on the balance sheet will be grossed up.
  • No leased assets will be included in the property, plant, and equipment line items of the balance sheet (except perhaps for pre-existing capital leases).
  • Profit and Loss geography will change as rent expense is replaced with amortization and interest charges.
  • Expense-recognition pattern will change to become front-end loaded (similar to a mortgage where more interest is recognized on the front end of the loan).
  • More potential differences between financial statement and tax reporting for leases will exist.
• Lease terms, contingent rentals, and other factors will need to be estimated and subsequently re-measured.
• The changes in accounting could have some broad impacts on debt covenants, real estate and financial strategies (lease vs. own), and other matters.

If you have any questions, please contact Kevin Loudon, Senior Manager, at 312-980-3358 or your Blackman Kallick representative. 

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.