This article originally appeared in the April 2012 issue of Smart Business Philadelphia magazine.

Proposed lease accounting rules could have a serious impact on businesses that have significant leasing activities.

A draft standard for lease accounting developed by the U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) will affect any business that enters into a long-term lease and result in significant accounting changes for both lessees and lessors.

There is a lot of controversy over this new draft standard for lease accounting. The current accounting guidance has been criticized for not requiring all lease commitments to be recorded on a company’s balance sheet, resulting in inconsistency for banks and other third parties that require a business’s financial statements. Under current standards, companies aren’t required to include operating lease commitments as liabilities on their balance sheet unless they meet certain criteria to be treated as capital leases, and some users of financial statements are seeking a more black-and-white approach.

How did the proposed lease changes come about?

Mainly, there has been feedback from users of financial statements, such as banks, that they are not getting a clear financial picture of a company’s leasing activities. Balance sheets don’t show the complete picture in some cases.

For example, companies are required to include capital leases on their balance sheets, but operating lease commitments are only included as a note disclosure to the financial statements. A company could be committed to paying a lease obligation, but that lease might not have been recorded on the balance sheet. Essentially, certain leasing activities could have been left off of the balance sheet, making the financial statements inconsistent with reality.

In reaction to this, the FASB and IASB created an exposure draft of proposed lease accounting changes. The proposed rules affect lessees and lessors, and there are significant changes for both parties. For now, there is still discussion, and a revised exposure draft is expected to be complete in the next several months.

How could the proposed changes impact businesses that lease space?

The new model would result in the elimination of off-balance-sheet lease financing for lessees. The proposed rules require that lessees record leasing arrangements based on a right-of-use model. Under that model, lessees would recognize an asset representing its right to use an underlying asset during the lease term and a liability representing its obligation to make lease payments during the lease term.

Additionally, there will be no distinction between operating and capital leases, and therefore, no ability for a lessee to leave a lease obligation off of the balance sheet. Depending on a company’s lease portfolio, this requirement could have a serious impact on the balance sheet.

For example, consider corporations that lease large facilities across the country. Under the new proposed guidance, these companies will be required to record assets (right-of-use) and liabilities to make lease payments. Interest expense will be recognized on the liability to make lease payments and the right-of-use asset will be amortized over the shorter of its estimated useful life or the lease term. It will change the income statement from a budgeting standpoint, because rent expense will be essentially replaced with interest and amortization expense.

Essentially, the proposed changes will result in assets and liabilities being ‘grossed up’ because all leasing transactions will be recognized on the balance sheet. This could deteriorate key leverage and capital ratios. Also, the proposed rules will require a system for gathering and tracking lease data, which could be extremely cumbersome.

How will lessors be affected by the proposed rules?

There are proposed changes to accounting by lessors also. The FASB and the IASB introduced the receivable and residual approach.

Under this approach, lessors would derecognize the underlying leased asset and initially measure the right to receive lease payments at the present value of the lease payments, along with a residual asset measured at the lease commencement. This model does not apply to short-term leases or leases of investment property.

How can businesses best prepare for these proposed lease accounting changes?

For now, the proposed lease accounting changes are still under debate. But it is prudent to consider how these rules will impact your business if they are put into effect tomorrow. How will this change your balance sheet? How could the rules impact budgeting?

Businesses of all sizes will see a definite difference in their financial statement presentation, so it’s important to get a handle on the lease commitments you currently have. Quantify those and project the potential financial impact on financial statements. And begin tracking and keeping careful lease records that will help you make business decisions about leases down the road. Now is the time to discuss with your banker any debt facilities that require financial covenants that could be revised based on lease accounting changes.

And businesses should consult with a trusted accounting adviser, who will help them implement any processes. An experienced accountant will guide you through these lease accounting changes and make recommendations to ease the process.●

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