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Changes Ahead for Organizations with Operating Leases

January 13, 2011

By Marcus Harwood, CPA

In August 2010, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued exposure drafts that, if finalized in their current form, would have a significant impact on how companies account for leases.  Both balance sheet and income statements would be impacted based on the proposed rules.  These changes will require management to incorporate significant judgments and estimates and would impact common analytical ratios such as debt to net worth and other widely observed performance metrics such as EBITDA. 

Current accounting rules require companies to assess whether a lease is an operating lease or a capital lease.  Operating lease expenses are recorded, as incurred.  Capital leases, on the other hand, are treated as financed acquisitions.  The leased item is recorded as an asset with a corresponding liability on the balance sheet.  Expense is recognized as the asset is amortized and interest expense on the lease obligation is incurred.

The exposure draft would essentially eliminate operating leases.  Key provisions for lessees are as follows:

  • The right to use a leased asset during the lease term and the obligation to make rental payments would be recognized as assets and liabilities, respectively, based on the present value of payments over the expected term of the lease.
  • The lease term would include any optional renewal periods that are more likely than not to be exercised.  In addition, lease payments would include contingent amounts.
  • Lease terms and contingent payments would be re-assessed each reporting period and estimates would be adjusted accordingly.

Lessors would apply a performance obligation approach if they retain significant risks or benefits related to the underlying asset.  Otherwise, they would apply a derecognition approach.

  • Under the performance obligation approach, a lessor recognizes a lease receivable representing the right to receive future lease payments and a "performance obligation" representing the obligation to allow the lessee to use the asset.  The value of the leased asset remains on lessor's books.
  • The de-recognition approach is similar to the performance obligation approach except that the leased asset, which is considered to be transferred, is removed from the lessor's balance sheet.

The proposed changes received much feedback from the public during the document’s comment period in 2010.  The public expressed concerns that the exposure draft was overly complex and sometimes inconsistent with the economics of the underlying transactions. As a result, the five major areas being reviewed are the definition of a lease, lease term, contingent payments, profit and loss recognition patterns, and lessor accounting.

The FASB and IASB are currently deliberating on these topics as they work to finalize the intended changes.  The existing proposal draft does not specify an effective date.  The final guidance is targeted for the second half of 2011, but before issuing the final document, the FASB intends to present the proposed amendments to existing accounting standards, as revised, again for public comment.

These proposed changes would have the most significant impact on companies with significant portfolios of operating leases.  Recent SEC estimates indicate that these accounting changes could require the recognition of an additional $1 trillion worth of operating leases.  Companies should begin to consider the nature of the judgments and estimates that would be required to comply with the new rules along with the impact on debt covenants, leverage ratios and various earnings measurements including EBITDA.


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