Just when you ‘lease’ expect It
- March 6, 2012
The Financial Accounting Standards Board (FASB), in conjunction with the International Accounting Standards Board (IASB), continues to work on its proposal for a new standard for the accounting for leases, which could have a major effect on financial statements, financial ratios and the way companies choose to lease assets.
The proposed treatment affects leases of property, plants and equipment, but excludes leases of intangible assets. FASB and IASB (collectively the boards) released their current thinking in the fourth quarter of 2011 and agreed unanimously to re-expose their proposals for a revised lease standard, which is expected to be issued in mid-2012.
Lessee accounting model
Historically, companies have accounted for leases as either operating leases or capital leases. While both lease types involved a company entering into an obligation for future payments related to the use of an asset, the operating lease model did not reflect that obligation on the balance sheet while the capital lease model did. As a result of this distinction and the various bright-line tests in the literature differentiating between the two, agreements could be structured to produce very different accounting treatment for similar transactions.
The proposed new rules try to remove these differences while increasing transparency and comparability between transactions. As a result, once the new rules are enacted, all leases would be capitalized and the distinction between “capital” and “operating” leases would cease to exist. The only exception will be for short-term leases of 12 months or less. Otherwise, all companies that are lessees will be required to book the present value of all future lease payments as a liability on their balance sheets, with a corresponding Right-of-Use (ROU) asset to comply with U.S. Generally Accepted Accounting Principles (GAAP). The liability will include all payments covered by the non-cancellable period of a lease agreement, plus any renewal options where there is a “significant economic incentive” to extend or not terminate. Both the ROU asset and the corresponding liability to make lease payments will be measured at the Present Value (PV) of the lease payments.
Currently, most companies reporting under GAAP detail future lease liabilities in the footnotes to the financial statements, rather than on their balance sheets. Once this new standard is adopted, it is estimated that companies following GAAP could need to record trillions of dollars of existing lease liabilities on their balance sheets. This will have significant implications for the companies and investors. Companies such as retailers, restaurant chains and banks that have many leased locations will be significantly affected. For many of those companies, interest-bearing debt (including lease obligations) will increase by 100 percent or more, with total assets generally reflecting smaller percentage increases.
Big changes to key operating metrics and debt covenant ratios
Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is often used to evaluate the cash flow and borrowing capacity for companies. EBITDA definitions generally do not add back operating lease rent expense. However, with the capitalization of all leases, rent expense will be replaced by depreciation, amortization and interest, which are normally added back in deriving EBITDA. This change is expected to increase EBITDA for most companies, with consumer companies expected to show increases of more than 20 percent.
Operating income is a key metric for shareholders of many public companies. Since some of the former rent expense will now be considered as interest expense, which is excluded from the calculation of operating income, many companies will likely see an increase in operating income. Retailers and restaurants are expected to show increases of greater than 10 percent.
The not-so-good news
The Debt-to-EBITDA ratio (also known as Debt-to-Cash-Flow ratio) is a common metric that lenders use in assessing the creditworthiness of borrowers. This metric tells lenders how many years of cash flow will be needed to repay the debt principal. The new lease accounting will result in both increases in EBITDA and debt. However, debt will generally increase at a faster rate than EBITDA, resulting in larger increases in companies’ Debt-to-EBITDA ratios. Larger ratios will imply that companies have proportionally less cash flow to cover their debt obligations, and in many cases, these ratios could double. As a result of these changes, companies could see a decrease in their borrowing capacities.
Lessor accounting model
Lessor accounting will change to an approach based on the “receivable and residual” model. Under this methodology, companies will recognize the lease receivable for the right to receive (RTR) lease payments, “at the present value of the lease payments.” An allocation will be made between the carrying value of the underlying asset being leased related to the ROU asset and the residual value.
Companies will be recording ROU assets and related liabilities that reflect the entire lease term, which makes the terms and renewal options critical. The longer the initial term — and the more likely the terms and circumstances would lead to a renewal — the larger the ROU asset and related liability that will need to be recorded on the balance sheet.
Virtually all leases are going to be required to be capitalized on the balance sheet. Companies may want to review debt covenants to determine how terms such as debt, EBITDA and cash flow are defined. Based on those definitions, it is advisable to consider the effect of new lease accounting on the debt covenants. Pro forma calculations of the effect of capitalization of leases on assets, debt and EBITDA may be useful in this process.
To the extent debt terms are negotiated in the future, companies may want to be proactive to carve out the effect of capitalized leases or new accounting pronouncements from the definition of debt in such debt agreements. Also, upon entering into and negotiating new leases, companies will also need to consider how lease renewal options and contingent rents will impact the magnitude of the liability they will need to record under the new rules.
Tom Visotsky, CPA, is a VSCPA past president and is currently an independent consultant in Richmond. He can be reached at firstname.lastname@example.org.
Jim Carter, CPA, is a partner with BDO USA LLP, in Richmond, and heads up the assurance practice for the firm in Virginia. He can be reached at email@example.com.