United States Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are reviewing existing lease accounting standards. Recently, FASB and IASB jointly published the discussion paper Leases: Preliminary Views, which proposes a new approach to lease accounting. This standard will not be enacted immediately. Through its usual course FASB and IASB will prepare and publish an exposure draft (2010) with a goal of implementing a new lease accounting standard in 2011 that would become effective sometime in 2012-2013. However, if and when implemented it may affect existing, pending and future leases.
Currently under accepted accounting practices and rules lessees must categorize a lease as either a capital lease (aka a finance lease) or as an operating lease. A capital lease is a lease that transfers substantially all risks and rewards incidental to ownership of the property to the lessee. All other leases are classified as operating leases. Capital leases are instruments to finance the purchase of an asset. On a balance sheet these capital leases would be categorized as an asset (the right to use) and as a corresponding liability (the obligation of payments).
The lessee in operating leases does not have to account for the lease on its balance sheet. Instead the lessee recognizes rental expense on its income statement as lease payments are payable. When a lease is structured as an operating lease, the lessee can avoid recognizing a debt obligation on the balance sheet. This different accounting treatment of capital and operating leases has given rise to a range of concerns from users of financial statements and investors.
Regardless of the form of the final standard that FASB and IASB adopts it appears that the distinction between operating and capital leases may be eliminated. Thus, all leases would be disclosed on the balance sheet. This concept is based on an assumption that in a lease the lessee obtains the right to use the property (an asset) and undertakes an obligation to pay rentals (a liability). The current proposal would peg the cost by determining the present value of all lease payments discounted using the lessee's incremental borrowing rate. The asset value would be measured accordingly.
This implementation may cause lessees' balance sheets to grow making many companies appear highly leveraged. EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) will likely increase as rent expense will be replaced with depreciation and interest expense.
The final effect of this joint proposal of FASB and IASB is unknown. The proposal requires more detail and refinement (e.g., how are subleases, contingent rents to be accounted, how will it affect lessor accounting). Whether the joint proposal becomes an official accounting standard or not it appears prudent to plan for the possibility that FASB will implement the basic premise -that all leases, both operating and capital, should be accounted for on a company's balance sheet as an asset and liability.
Although it may take some time for this concept to become an official accounting standard it does not appear to be advisable to rely upon existing leases being "grandfathered in or exempted from any final change to the lease accounting standard. Given the potential material effect on a company's financial statement (from both current and pending leases) it would be sensible for companies to carefully analyze their current leases and leasing policies. Companies with current lease transactions characterized and treated as an operating lease where such characterization and treatment is critical should recognize and allow for the possibility that the current accounting treatment may be changed several years into the term of that lease.
This article is intended for general information purposes only and shall not be construed as legal advice or legal opinions on any specific facts or circumstances.