Dave Smith

Will balance sheets soon look very different and your decision to lease take on new complications?

The Financial Accounting Standards Board has released a proposed change to lease accounting that would have an immediate and substantial impact on businesses and nonprofit organizations of all sizes that are either lessees or lessors of real property and/or equipment. This article will focus on the impact on lessees.

Because of the extent of the changes and the extent of leasing transactions in the U.S. economy (approximately $600 billion annually for equipment alone), this is a very significant change in terms of the number of entities that will be noticeably affected by it. The FASB is expected to finalize its proposal in 2011, which would likely make it effective in 2012 or 2013.

Though still in the proposal stage, the FASB has been targeting lease accounting for some time and a change is almost guaranteed. It is just a matter of details and timing.

Why should everyone take notice of this? The change would result in literally more than a trillion dollars of assets and liabilities that were not there before suddenly appearing on the balance sheets of U.S. companies (it is estimated that U.S. public companies alone would add $1.3 trillion to their balance sheets). This could result in throwing many debt covenants into unexpected default if they are not adjusted.

Current U.S. accounting standards require leases to be classified as either capital leases or operating leases. Operating leases result only in an expense and never appear on a lessee's balance sheet, while capital leases require an asset and liability to be presented on a lessee's balance sheet. A "bright-line" distinction is made between the two types of leases, meaning that very specific thresholds determine whether a lease must be capitalized.

This results in most leases getting structured as operating leases, which are much more convenient to account for by lessees. The decision to lease is sometimes made for the purpose of bypassing the balance sheet, although the primary financial motivation for leasing is usually to protect cash flow, since a company can use a leased asset to generate revenue immediately with no money down, while paying for it over time.

The new standard would virtually eliminate the operating lease. Nearly all leases would need to be capitalized. This by itself will end the "convenient accounting" aspect of leases. All lessees would need to recognize an asset and depreciate it, while recognizing the present value of future lease payments as a liability. Instead of one expense stream for lease payments, there would now be two lease expense streams — an amortization and an interest expense component.

This will result in additional computations and financial statement disclosures not necessary for current operating leases. The splitting of expense will also result in a front-loading of expense, which would become greater as the lease term increases since interest expense would be higher and represent the bulk of the payment stream in the early years.

A few other new wrinkles include the addition of renewal periods when valuing the lease. For example, if a lease term is 10 years with a likely six-year renewal option, the lessee would need to recognize 16 years' worth of assets and liabilities, even though the current legal lease obligation is only 10 years. Lease payments would also be moved on the cash flow statement, from an operating activity to a financing activity.

Conceptually, the new standard would provide a more faithful representation of assets and liabilities, and would align U.S. standards with international standards, which already require the capitalization of most leases. The FASB expects these changes to provide better information to users of financial statements.

However, there are many practical issues to consider. All organizations with leasing transactions that prepare GAAP-basis financial statements should be aware of the potential implications of these lease accounting changes. At Wright Griffin Davis and Co. (soon to become Rehmann) we are available to assist you with any questions and/or concerns you may have.

Dave Smith is a CPA with Wright Griffin Davis and Co. CPAs.