Lease Accounting

Lease Accounting

Every Lease Will Require the Recording of a Liability

The rules for lease accounting were first established in 1976 (FAS 13). Under existing rules, there were two ways to account for leases. For operating leases, the most common, the lessee records rent expense each month over the term of the lease. Some leases were capitalized (by recording capitalization) if they devoted some attention to the words in the lease agreement. There are the subsequent amendments to those rules, many believed that lease accounting rules were unnecessarily complex. Those rules may seem simple compared to the changes to lease accounting that the FASB has recently proposed.

Reflecting the FASB’s inclination towards a balance sheet approach to accounting, it has proposed new lease accounting rules that would dramatically change the existing accounting. In sum, virtually all leases will be capitalized – leases will no longer be classified as “operating leases”. The proposed rules are based on the “right-of-use” model. All assets and liabilities arising from lease transactions of property, plant and equipment (leasing of intangibles is excluded) will now be recognized on the balance sheet.

The accounting from both the lessee’s and the lessor’s perspective will be similar. Lessees would capitalize an asset (representing the right-of-use of that asset) and record a liability to make lease payments. A lessor would recognize an asset representing its right to receive lease payments and, depending on its remaining exposure to risks or benefits associated with the underlying asset, would either recognize a lease liability (the performance obligation approach), or record revenue from the “sale” of the asset and derecognizing the underlying asset with a corresponding charge to cost of sales.

The assets and liabilities resulting from the lease transaction would be measured based on the longest possible lease term that is “more likely than not” to occur and the present value of future lease payments. The present value of future lease payments would use an expected outcome approach. Contingent rentals (e.g., based on percentage of sales or rent increases based on such future factors as the CPI) would be factored into the measurement of the asset and liability as part of future lease payments. Every entity would have to reassess the estimated impact of lease renewal and contingent rental terms and adjust the asset and liability as conditions change.

The proposal provides some relief for lessees by “simplifying” the accounting for leases that have a maximum term of 12 months or less. For such short-term leases, the entity can record the asset and liability based on the undiscounted amount of future lease payments.

The impact on the lessee’s financial statements will be significant. Rather than recording rent expense on a straight-line basis over the term of the lease, expenses would reflect the amortization of the asset and the interest from the related obligation. In most cases, this will front-load the negative impact on EBITDA.

With the exception of simple leases that are presently treated as “capital leases”, preexisting leases will not be grandfathered, so virtually every lease will need to be remeasured in light of the new rules. The new rules will be applied retrospectively – meaning that all outstanding leases at the date of the earliest period presented in your financial statements will be recorded as assets and liabilities. The final standard is expected in mid-2011 with an effective date perhaps as early as calendar 2012. Based on recent FASB pronouncements, private companies may be given a one year deferral to 2013.

Since this is still in the proposal stage, there is a long way to go. However, most observers expect the final standard to be very close to the exposure draft. It will be important for all entities to address the potential new rules soon (e.g., when discussing loan renewals, when negotiating leases, and by establishing appropriate accounting processes). For entities with a large number of leases (e.g., retail stores) the transition could be very complex.

We welcome the opportunity to help you evaluate the potential impact of these rules on your entity and to help you to establish a plan for dealing with it.