Preparing for the new lease accounting.

• Author: Hepp, John
• Position: ACCOUNTING

Is it a lease, or not a lease?

This is just one of the considerations in the new lease accounting proposal, which could lead to major changes in how leases are negotiated and administered. Though implementation is in the future, the long-term nature of many leases means it's not too early to start planning.

While the recent financial crisis has focused increased attention on off-balance sheet liabilities, proposed changes to lease accounting are the result of a project that dates back to an earlier round of accounting scandals and the subsequent passage of the Sarbanes-Oxley Act of 2002. The current proposal would eliminate a major category of off-balance sheet liabilities: Operating leases.

All leases will create a lease obligation liability and a corresponding right-of-use asset on the balance sheet, similar to the current accounting for capital leases. However, the proposed changes go beyond the current rules for recording leases as capital leases.

The new rules would require consideration of additional items--such as contingent rental payments and optional renewal periods--that will add complexity to the initial valuation of a lease obligation. Leases with contingent rentals or option periods may need to be re-evaluated every reporting period.

The scope of the new standard will also require evaluation of lease contracts to determine whether any of the payments are for distinct services. These services would not be included with the lease obligation. The additional complexity is likely to change how lease terms are negotiated and structured.

The proposal will also affect how rent expense is reported on the income statement. Currently, rent expense is recognized as part of operating income and included in calculation of earnings before interest, taxes, depreciation and amortization (EBITDA).

Under the new proposal, part of rent payments will be recognized as interest expense and the right-of-use asset will be depreciated, moving the expense out of the current definition of EBITDA. In addition, more interest expense will be attributed to the early years of a lease, accelerating the recognition of overall expense.

The scope of the changes may require redesign and reevaluation of existing procedures for negotiating, administering, recording and reporting leases in the financial statements. Entities with significant leasing activities may also find it necessary to redesign and test their internal controls over leasing to ensure compliance with the proposed accounting rules and expanded disclosure requirements.

Evaluating a New Lease

The proposed standard defines a lease as "a contract in which the right to use a specified asset is conveyed, for a period of time, in exchange for consideration." Similar to the existing standards, any agreement that transfers to the lessee more or less exclusive rights to use property, plant and equipment (or its output) would be classified as a lease.

SUMMARY OF KEY CHANGES FOR OPERATING LEASES Topic Existing U.S. Proposed Model Expected Impact GAAP OVERALL Operating leases Record an asset Increased assets RECOGNITION are "off balance and liability for and liabilities sheet." all leases based on the balance on the most sheet. likely future rent payments and lease term. PAYMENTS FOR Also off balance Remains off Need to SERVICES sheet. balance sheet. distinguish payments for rent from payments for services. LEASE TERM Include option Capitalize the Need to reassess periods with most likely lease most likely lease bargain renewals term, including term each or periods prior option periods. reporting period to a bargain and adjust purchase option. financial statements, if needed. CONTINGENT Generally Capitalize most Need to estimate RENTS recognize when likely estimated and capitalize incurred. future payments most likely and include in future payments recorded asset each reporting and liability. period and adjust through income. INCOME Record rent Recognize Increased EBITDA, STATEMENT expense on a interest expense depreciation PRESENTATION straight-line on the obligation expense and...