Are operating leases dead?

• Author: Boyadjis, George
• Position: Members speak out

Potential changes in lease accounting are likely to have huge consequences for the balance sheets of most companies and nonprofits. Operating leases will become capital leases, resulting in the shift of trillions of dollars onto balance sheets. With all leases for commercial real estate space being capitalized in this way, the assets and debt of many companies will increase dramatically.

In addition, measurements of earnings before interest, taxes, depreciation and amortization (EBITDA) will increase as rent expense disappears and is replaced by higher leased asset amortization and interest expenses.

With so much change in the offing, FEI members need to understand the proposed new accounting standards and plan now. Why is this so important? Because all leases that exist as of the official change will have to conform to the new standards and current operating lease treatment will not be grandfathered. In addition, a recent survey by Core Net Global indicated that 83 percent of companies were unfamiliar with the proposed changes.

Why Proposed Changes Now?

The Financial Accounting Standards Board and the International Accounting Standards Board recently issued a joint Discussion Paper detailing the changes to operating leases, a component in the boards' convergence program. The impetus for the proposed changes dates back to the accounting scandals that raised concerns about off-balance sheet accounting.

Concerns about the current rules include: Undisclosed liabilities in the form of lease obligations, lack of transparency and comparability and "form over substance" transaction structures.

While balance sheets are adjusted by bankers and analysts to approximate the debt implied by operating leases, critics claim the adjustments are inconsistent and frequently understate the lease obligations.

Specifics of the New Proposal

The proposed standards presume that all leases give rise to assets (the "right to use" the leased assets) and liabilities (future rental payments). The proposed new principles for lessee accounting are:

* All leases, including leases at the cutover date, will be treated as capital leases.

* Leases will be capitalized based on the present value of the lease obligation, using the company's incremental borrowing rate.

* Capitalized lease values will include base rent, residual payments, obligated renewals and contingent rents.

* Rent expense will cease to exist; instead, interest expense and leasehold amortization expenses will...