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Proposed Changes to Lease Accounting Standards — The Classic Cookie-Cutter Standard Is Likely to Be Retired

What’s “ahead” in this article:

> Key Points for Lessees
> Change and Volatility on Income Statement
> FAQs
> Suggested Next Steps
> Two Final Notes

(click on these links to go directly to that section)

FASB issued an exposure draft in August 2010 to substantially revamp lease accounting; however its effective date has not yet been set.

Lessors will be affected by this proposed standard, and we invite them to call their Blackman Kallick accounting team to discuss it.  In the meantime, we are going to focus on its impact on lessees in this newsletter.

Key Points for Lessees

• No More Operating Leases — Watch Those Debt Covenants and Credit Ratings.

Yes indeed, if the proposed standard is approved, leases will be recorded on the balance sheet. An asset, representing the right to use an asset for a specified period, and the corresponding liability, are recorded at the beginning of the lease. So the balance sheet will be bigger.

The basis for the amounts recorded on the balance sheet is the present value of lease payments (asset also includes lessee’s initial direct costs) over the lease term. Not as simple as it sounds . . . it is probability based (see more details below).

The asset is amortized and is subject to the amortizable intangible impairment rules.

Lease payments are accounted for as payments of interest and principal.

Leverage ratios will increase and capital ratios will decrease. Checking now how your lender ratios might be affected should give you time to get any necessary covenants fixed to avoid unnecessary covenant breaches.

• How About That EBITDA?

If EBITDA is important to you, then you may be very happy with this proposed standard. Once the lease is on the balance sheet, rent expense goes away and depreciation and interest expense come in. EBITDA goes up.

Sounds simple? Keep reading . . .

Change and Volatility on Income Statement

Net income pattern itself would change. Rent expense is generally straight-line under existing rules. Depreciation and interest expense would replace rent under the proposed standard, resulting in higher expense in early years of the lease and lower expense in later years (barring changes described below). In addition, as noted above, the asset and liability that would be initially set up are based on a probability-based calculation involving lease term and lease payments.

Lease term would be based upon probability-based expectations. Currently lease term is determined based upon lease contract, along with a bright-line evaluation of renewal terms. Under proposed standard, lease term would be the longest possible term that is more likely than not to occur (probability based)

• Consideration of all facts and circumstances 
• Important to carefully consider this because the lease term needs to be considered each reporting period.

What if you think you might change your plans about how long you will lease the asset? Let’s say you previously thought you would exercise a renewal option on your facilities lease. However, you now think that it makes more sense NOT to exercise an option to renew your facilities lease because you have found that you can get better deals on some other properties. The proposed standard would have you reassess the amount recorded for the asset and liability. In this case, the resulting change would cause a decrease in the asset and liability and an abrupt drop in that year’s amortization expense and interest expense.

Let’s say instead that you had initially decided that it wasn’t likely that you would extend the lease, but after looking around at other properties, you now believe that it is more likely that you will extend the lease. You would then increase the asset and liability. And that increase in the asset and liability causes a spike up in that year’s amortization expense and interest expense.

Lease payments would include base rent payments, estimated contingent rents, residual value guarantees, and expected termination penalties, whereas currently, contingent rents are not included and residual value guarantees and termination penalties are included in different ways.

Accounting for contingent rent (e.g., additional rent expense based upon sales) would be different. Under existing standards, contingent rent is currently recognized when fixed and determinable. Under proposed standard, estimated contingent rent is recognized at the beginning of the lease and is reassessed each accounting period.

What if actual contingent rent is different from the amount you estimated? If the actual contingent rent relates to current or past periods, the difference goes to the income statement. If the estimate of future contingent rent changes, the asset and liability are adjusted up or down as appropriate, with corresponding effects on that year’s amortization and interest expense.

The Statement of Cash Flows would change too — lease payments would be a financing activity rather than operating activity.

Other Common Questions and Answers

Might This Even Change Your Decision Making in Lease vs. Buy Opportunities? You may find leasing less appealing if the old accounting was important to you. You may also find that the removal of the old accounting puts the leasing option on a more equal playing field with other financing options, and you can compare interest rates, etc.

If you do decide to lease, consider accounting complexities as you negotiate terms, such as contingent rent, renewal options, etc. But don’t let accounting concerns keep you from getting the best overall deal. And, you don’t want to forget to consider the lower upfront cash requirement and flexibility that leasing may offer you.

Why, Why, Why Is the FASB Doing This to Us All? To get rid of an easily manipulated cookie-cutter standard that has kept debt off the balance sheet, as well as to achieve greater consistency with international standards

Are There Any Exceptions? Sort of. A lessee can elect for leases with a maximum possible lease term of a year or less…

• to measure the asset and liability on an undiscounted basis, and
• to recognize lease payments on the income statement.

Be careful to use the proposed standard’s definition of lease term — and all bets are off if related parties are involved.

Are Only Leases That We Sign After the Effective Date Subject to the Standards? Unfortunately, no. The proposed standard will impact all leases in place on the first day of the earliest period presented in your financial statements, in the year in which the standard is effective. Therefore, gathering information, analyzing the agreements, etc. would need to be done for any leases in place at that date.

How Likely Is It That FASB Will Approve the Proposed Standard? The exposure draft was passed unanimously by both FASB and the international accounting standard setters, so they appear to feel that they have nailed it. They have received some comment letters, and will be re-deliberating some fine points. However, we do not expect them to change the basic concept of recording most leases on the balance sheet.

Suggested Next Steps for Lessees

We recommend the following:

Do an initial check on the impact the proposed standard could have on any debt covenants you have in place right now, so you have an idea of where you might need to go with your lender. And maybe even start the discussions with that lender.

Consider if you have any compensation plans or other agreements that would be affected by this proposed standard and start the process to achieve an equitable result for both sides.

For leases that extend at least through 2012, analyze the agreements to determine how the proposed standard would apply to them. The effective date is not yet known, but we are not expecting an effective date prior to 2013.

For any leases that you sign from this point forward that extend through 2012, gather and analyze in the same fashion.

Depending upon the volume and complexity of your leases, you may want to evaluate the sufficiency of your systems and controls, as the accounting process now involves periodic reassessments of estimates, as described above, that you did not previously need to perform. Your internal budgeting process may also need some tweaking.

Two Final, Important Notes

1. This issue includes a brief overview of the proposed standard. If you have any questions on this or another upcoming standard please contact us. We will address your question in a subsequent issue, space permitting.
   
   Also, please do contact your Blackman Kallick accounting team for assistance in addressing your specific facts and circumstances. Your Blackman Kallick accounting team is happy to help you sort through this, or just help you get started on the “road ahead.”
2. FASB is still open for written comments on this proposed standard until December 15, 2010 (see fasb.org for details).
   
   In addition, FASB has scheduled a nonpublic-entity roundtable for this proposed standard on Wednesday, January 5, 2011 in Chicago from 1-4 p.m. Email director@fasb.org right away if you would like to participate in the roundtable itself. If you would just like to observe, register at the same source.

Blackman Kallick’s The Road Ahead-Accounting Updates publication has been prepared for general information on the specified topic. Application to your particular facts and circumstances should be carefully considered in light of the actual accounting standard or exposure draft and in consultation with your Blackman Kallick accounting team.

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.