Significant Changes in Lease Accounting

by Amanda Meko, CPA | Partner, Director of the Audit & Other Assurance Services Group

Many businesses enter into lease arrangements. Think about lease arrangements your company has. You probably lease office equipment, like a copier and a postage meter. You may lease equipment or vehicles. You may also lease space, such as an office or an entire building. Many of these leases are currently treated as operating leases. That is, you record rental expense in your income statement as you make payments on the lease. Now imagine how different your financial statements would look if you had to treat any long-term lease (greater than twelve months) as a capital lease. Under the new proposed rules, an asset and a liability would be recorded in the balance sheet, and the lease payments would be split into interest expense and a reduction of the liability, instead of showing up as rent expense. The asset would be amortized as noted below. For some lease arrangements, such as office equipment, the impact may not be that great. However, a building lease could have a substantial impact on the balance sheet and related debt and equity ratios.

The Financial Accounting Standards Board (FASB) is working on changes in lease accounting rules to require such a treatment. FASB released a trial version of the new rules, known as an exposure draft, in 2010. Exposure drafts are used to test public reactions to proposed changes and also to solicit input from both issuers and users of financial statements. Because of the significant impact the rule change will have, FASB announced in July that it plans to re-expose the draft in the 4^th quarter of 2011.

The new rules as previously drafted will require lessees to record an asset representing its right to use the asset and a corresponding liability to make lease payments based on the present value of the future payments required under lease arrangements with terms greater than twelve months. This transaction would be recorded based on the longest lease term that is more likely than not to occur. That means that you would have to take into account options to extend or terminate the lease. Those options would need to be reconsidered, and the corresponding asset and liability may need adjusted when facts and circumstances would indicate significant changes from the how the lease was previously reported. On an ongoing basis, the asset would be amortized over the life of the lease, and the liability would be reduced by the lease payments, with a corresponding interest expense recorded, similar to other long-term financing arrangements. It is probable that FASB will require retrospective application of the new rules such that all leases existing at the date of required application would be capitalized.

If you have bank financing arrangements that require you to meet certain covenants, you should consider how the rule changes may impact those covenants. For some companies, this may require the addition of a significant amount of debt to their balance sheets and ultimately an unfavorable increase in their debt to equity ratio. Conversely, another common metric, “earnings before interest, taxes, depreciation and amortization” (EBITDA) would look more favorable, due to the absence of rent expense in the income statement. Understanding the impact now will provide for timely conversations with your loan officer to avoid covenant failure after the fact.

The effective date of these changes is not yet final, but is expected to be 2014. However, it is not too early to start planning as all long-term leases will be making their way to the balance sheet.