FASB Changes May Include Recording Leases as Debt
According to a discussion paper published by the Financial Accounting Standards Board (FASB), change is coming that will have far-reaching effects on companies that lease real estate or equipment. Per the
World Leasing Yearbook 2009, the annual volume of leases in 2007 totaled $760 billion. However, despite the massive size of this global industry, quite often, the assets and liabilities arising from these contracts are not reported on balance sheets.
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This is a big deal because it will modify the definition of debt.
—Jim Davidson, Construction and
Real Estate Principal
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“This is a big deal because it will modify the definition of debt,” says Jim Davidson, construction and real estate principal with LarsonAllen.
The anticipated revision will alter several critical financial statement ratios, which could affect access to capital, so creditors need to be informed and educated early on. A final statement on this proposed model is expected to be released in 2010 or 2011.
Current standards: capital vs. operating
Currently, under generally accepted accounting principles (GAAP), accounting for leases defined as “operating” is substantially different than accounting for leases defined as “capital.” Operating leases are recorded simply by recognizing the recurring lease payment as an expense over the lease term. If a lease is classified as capital, assets (the leased equipment or real estate) and liabilities (the future required payments) are recorded on an entity’s balance sheet. Under the anticipated model, almost all leases would be classified as capital.
“Presently, many companies prefer leases over purchases because lease details can be contained in a financial statement footnote rather than on the balance sheet itself,” explains Steve Richards, construction and real estate manager with LarsonAllen. Other organizations carefully structure lease transactions to avoid the capital lease classification, which makes their financial ratios appear stronger. The new rules will require more uniform accounting for lease obligations.
Lease rights and obligations
FASB’s new approach suggests lease contracts always create rights and obligations that meet the definition of assets and liabilities. Leasing a piece of equipment or real estate, for example, always gives the lessee the right to use the asset and the obligation to pay for it over time. These rights and obligations exist without regard to the lessee obtaining risks and rewards of ownership. As a result, lessees will have to more concretely account for these assets and liabilities on their financial statements.
Changes to financial statements
Although equity will not be significantly affected, nor will the fundamental economics of an entity’s situation change, the new standards will impact certain financial statement indicators and ratios. For one, creditors consider working capital and the current ratio key indicators. Recording all lease contracts on the balance sheet will increase non-current assets (property and equipment) as well as current and long-term debt for future lease payments. Both the working capital and current ratios will decrease, and analysts could take this as an indication of an increased reliance on cash, and the use of current assets to pay its obligations.
Similarly, the debt coverage ratio describes the level of cash flow available to support each dollar of current debt. Any increase to current debt—which would be the result of capitalizing all lease contracts—would weaken this ratio and indicate an increased reliance on cash flow to finance debt. Finally, as debt increases, the debt-to-equity ratio increases, and from the perspective of a creditor or financial analyst, an entity’s financial statement may appear to reveal more risk.
“Without any change in the economic substance of lease transactions,” says Davidson, “the new standard will make financial statements appear less favorable by today’s metrics.”
Effect on lessors
The initial FASB discussion memorandum mainly dealt with lessee accounting but also outlines some issues related to lessor accounting. Issues related to parallel accounting will most likely be examined: if the lessee adds an asset and a liability, what gets recorded on the lessor side? The FASB will continue to discuss this topic throughout the summer of 2010. However, there is still significant controversy over lessor accounting.
Future planning implications
Beside significantly increasing the reporting of assets and liabilities, the new requirements will also add related recordkeeping, because asset and liability schedules must be maintained for assets acquired under any lease. Audit procedures will also need to be modified.
“Though, this is a positive move toward more uniform reporting, it is also an additional step in a series of changes to accounting standards that appear to be making it more difficult for non-accountants to understand financial statements,” says Richards.
What to do now
Entities with significant lease arrangements should consult their accountants now to determine the effects of this new model on financial statements.
Early discussions with creditors and others who use financial statements will be important. Financial statements will be changing, some significantly, and educating sureties regarding the change prior to its implementation will help prevent unwelcome surprises. In addition, as new bank loans are negotiated, be certain bankers understand the implications of the new standard and how ratios will be impacted.
Though a final statement on this issue is expected to be released in 2010 or 2011, leases signed in the near future will ultimately be affected. So it would be wise to analyze each entity’s financial statement and lease agreements before the new rules are adopted.
For background information on this topic, read FASB’s discussion paper, which was published on March 19, 2009.
Jim Davidson, Construction and Real Estate Principal
jdavidson@larsonallen.com or 612-376-4536
Steve Richards, Construction and Real Estate Manager
srichards@larsonallen.com or 239-280-3516
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