At first glance, it doesn’t appear these businesses have much in common.
Micki owns a small chain of restaurants.
James is the CEO of a commuter airline.
Ian’s family operates a prestigious retail jewelry business.
Leigh manages a company that provides other businesses with short-term office solutions, including administrative staff, furniture and equipment.
But look again.
Micki’s restaurants operate in leased buildings. James’ airline leases its planes. Ian’s retail locations are also leased, as is much of the business’ furniture and fixtures. Leigh’s company leases its furniture, copiers, printers, fax machines and other office equipment.
All of these companies lease assets that, under current accounting standards, may not be reflected on their balance sheets.
Proposed Accounting Standards
Under a new accounting standard proposed by the Financial Accounting Standards Board and the International Accounting Standards Board, the accounting treatment for these leases may change―with a potentially significant impact on assets and liabilities reported on the balance sheet.
Off-balance-sheet leasing activity in the U.S. has been estimated in the hundreds of billions of dollars. Referred to as operating leases, the payment commitments associated with these leases are disclosed in the notes to the financial statements and not reported on a company’s balance sheet. As a result, proponents of the rule change believe that assets and liabilities are understated and current lease accounting―which dates back some 35 years―is “broken.”
According to Sir David Tweedie, chairman of the International Accounting Standards Board, “Much of the estimated annual $640 billion of lease commitments fails to appear on the balance sheets of lessees, thereby giving a false impression of companies’ liabilities.”
To address the problem, the Financial Accounting Standards Board and the International Accounting Standards Board recently issued an exposure draft with proposed new accounting rules intended to enhance transparency and standardize the accounting treatment of leases. Again quoting Sir David Tweedie, “Our proposals would result in better and more complete financial reporting information about lease contracts being available to investors.”
The proposed rules affect leases of real and personal property. They do not address intangibles, natural resources or biological assets.
Rules for Lessees
Generally, the proposed rules would require companies to record a lease liability and a corresponding right-to-use asset on the balance sheet at an amount equal to the present value of the lease payments over the term of the lease, including any likely renewals and contingent amounts.
The proposed rule change also affects the company’s income statement. Rather than the current approach, which recognizes a consistent, straight-line lease or rent expense, the leased asset would be depreciated/amortized and imputed interest expense would be recognized related to the lease liability. There would be certain new disclosure requirements, too.
The proposed changes will have implications for convenant and financial calculations such as leverage ratios, debt service coverage and EBITDA.
Lessors aren’t exempt from the proposed changes. They would recognize a receivable for the expected operating lease payments and a liability for deferred revenue, However, the lessor’s accounting treatment for a specific lease will depend on whether it “retains exposure to significant risks or benefits associated with the underlying asset.”
Rules for Lessors
It’s important to understand that, at this point, the rules are only proposed―they’re subject to revision based on public comments and the results from other public outreach activities. The current comment period ends December 15, 2010, and it’s expected that the proposed rules will then be revised―with a final accounting standard expected sometime in 2011 or 2012.
Timeline for Implementation
It’s likely that the final rule won’t actually take effect for some time thereafter, providing companies with time to implement changes to financial reporting processes and systems, and to consider renegotiating covenants with lenders.
So, What Does This Mean for You?
If your organization leases real or personal property, either as a lessee or lessor, the proposed changes could have business consequences that you should consider and prepare for.
Your advisor at Bader Martin can help you to analyze the potential impacts and keep you informed of any changes to the proposed rules and expected timeline.
Your advisor can also participate in conversations with your banker when the time comes to address any impact the changes could have on the terms of your credit facilites.
