New Accounting Rules on the Horizon for Leases

The Financial Accounting Standards Board (FASB) is in the final stages of approving changes to the rules that govern lease accounting in the United States. Once in place, these rules could have a major impact on the balance sheets of companies that lease real estate and other types of assets.

Under current accounting standards, FASB recognizes two categories of leases:

• Capital Lease: This type of lease transfers to the lessee substantially all of the obligations and benefits of owning a specific asset and, under applicable accounting standards, is treated in many respects the same as a purchase. The lessee is required to recognize the leased property as an asset on its balance sheet and is further required to reflect a related liability with respect to the obligation to make rental payments. In addition, the lessee depreciates the leased asset and apportions rental payments between interest expense and a reduction of its liability under the lease.
   
• Operating Lease: This category includes any lease that is not classified as a capital lease. The lessee does not recognize any asset or liability on its balance sheet and records as an expense in each accounting period the rent that is payable under the lease, determined on a straight-line basis over the term of the lease.

Once approved, FASB's proposed changes will eliminate the concept of an operating lease and require that all leases be treated as capital leases. Under the new rules, which will apply to all leases that are in effect as of the date the rule is implemented, a lessee will not recognize a rent expense on its income statement. Rather, a lessee's balance sheet will reflect the lease as an asset, the value of which is equal to the present value of the lease obligation. A corresponding liability will be included on the lessee's balance statement to reflect the total rent to be paid over the term of the lease, including scheduled rent increases, contingent rent (e.g., percentage rent payable under a retail lease) and, under certain circumstances, rent that would be payable under an option to extend the term of the lease.

For parties involved in a lease, a number of important issues may arise out of the proposed FASB rule changes:

1. Lessees may be motivated to lease less space and for shorter lease terms. In addition, lessees may be motivated to purchase—rather than lease—real estate or equipment.
2. Lessee balance sheets, especially for businesses with a large number of leases, will appear to be more highly leveraged. As a result, lessees may fall out of compliance with loan covenants that compare debt to total assets. Lessees should discuss the impact of the new rules with their lenders and make appropriate adjustments to loan covenants.
3. Earnings before interest, tax, depreciation and amortization (EBITDA) for lessees will go up because the proposed new rule replaces rent expense with interest and depreciation expense, neither of which are included in EBITDA. As a result, lenders may want to review loan covenants with customers that lease assets based on EBITDA and make appropriate adjustments.

What is the expected timetable for the new rules? The FASB released a draft on August 17, 2010, with a request for comments by December 15, 2010. Although no implementation date has been set, the final standard could be issued as early as mid-2011 and become effective in 2012. Therefore, it is not too soon to begin preparing for the anticipated changes.