Accounting for leases has been fairly well settled for the last 35 years. In August 2010, the Financial Accounting Standards Board issued a proposal that would dramatically change the accounting for operating leases, which is a significant source of financing for some business organizations.
The existing guidelines are probably the best example of the “bright-line,” rules-based way generally accepted accounting principles (“GAAP”) in the US have been set in the past. It took many revisions and interpretations to the original 1976 standard to get it right, because there were just as many innovators who would craft leasing arrangements to just barely meet the precise definitions of an operating lease.
The new proposal is one of the last significant areas to conform US standards to the more principles-based international rules. The proposal addresses a valid criticism that our current accounting does not record all lease obligations on the balance sheet.
Here are some of the more important elements and ramifications of the proposed rule:
- For the lessee, all leases would be recorded at inception on the balance sheet as a roughly equal amount of a liability and a “right-to-use” asset. The accounting would then be similar to the present practice for capital leases.
- Expensing patterns will be “front-loaded” because operating lease rent expense will be replaced by depreciation and interest expense charges. Just like a home mortgage, a much larger portion of the monthly payment in the early years is for interest.
- Grandfathering of existing leases is not permitted, although there will not be any one-time earnings charge upon adoption.
- Companies may need to re-negotiate debt covenants; leverage and capital ratios will be negatively impacted; EBITDA will actually improve.
- Companies will be inclined to seek leases with shorter terms, or even month-to-month arrangements.
For more information on Lease Accounting, contact one of the Real Estate professionals at Skoda Minotti by calling (440) 449-6800.