The Financial Accounting Standards Board (FASB) circulated on August 17, 2010 an Exposure Draft (ED) presaging a major overhaul in the accounting for leases by both lessors and lessees.1 The comment period for the Exposure Draft closed on December 15, 2010 with over 780 comment letters submitted. If it had been adopted in the exposed form, the impact of the proposed rule changes on companies that utilize lease financing, particularly retailers, could have been dramatic.

However, decisions reached at FASB/International Accounting Standards Board (IASB) Joint Board Meetings held on February 16, 2011 and February 17, 2011 (which were couched in terms of being tentative) indicate that FASB and IASB are taking a more practical approach to lease accounting than originally set forth in the ED.2 On three important issues, the joint boards appear to have listened to a number of the concerns and comments voiced in the comment letters. With regard to off-balance sheet treatment of leases, the boards have agreed that distinctions should be made between “finance leases” and “other-than-finance leases” with the effect being that the latter type of lease would not be recognized on balance sheet. The boards alleviated concerns about estimating the term of a lease which, under the ED would have included more likely than not renewal period options, by raising the threshold for inclusion of renewal terms to situations where there is a significant economic incentive for a lessee to exercise such options. Finally, contingent lease payments should be included in a lessee’s liability only to the extent such payments depend on an index or rate or are reasonably certain to occur.

This DechertOnPoint will address these recent developments from the perspective of the lessee.

Past Practice

In 1976, FASB adopted Statement of Financial Accounting Standard No. 13, which sets forth specific rules for determining whether a lease should be accounted for as an “operating lease,” which would not appear on the balance sheet (although it would be disclosed in footnotes), or a “capital lease,” which would be treated the same as conventional debt on the balance sheet. Briefly put, the rules were that a lease was a capital lease if (i) it transfers ownership of the asset to the lessee at the end of the lease term, (ii) it contains a bargain purchase option, (iii) the term of the lease is equal to 75% or more of the estimated economic life of the leased asset, and (iv) the present value at the beginning of the lease term of the minimum lease payments equals or exceeds 90% of the fair value of the leased asset. Determining the present value of future rent necessitates a determination of a discount factor. FASB 13 indicated that the discount factor should be the lessee’s incremental borrowing rate unless it is practicable for the lessee to learn the implicit rate of interest in the lease and the implicit rate is lower than the lessee’s incremental borrowing rate. There is some element of judgment involved in selecting an appropriate discount rate and a cottage industry developed involving software that could calculate the rents that would amount to 89.99% of the fair value of the leased asset. With these rules, a fairly bright line was in place to keep a lease off a lessee’s balance sheet.

In 1988, FASB adopted Financial Accounting Standard No. 98 addressing sale lease back accounting which, among other things, addressed a lessee’s “continuing involvement” in a real estate asset as something other than a mere lessee. Continuing involvement, such as an option to repurchase the leased asset or a guarantee of the lessor’s return on investment, would disqualify a lease for operating lease treatment.

The Pending Proposal and Recent Decisions

Balance Sheet Recognition of Leases

The transformation of lease accounting rules contem-plated by FASB Exposure Drafts would have abolished the distinction between capital and operating leases and would have required that virtually all leases appear as a separate item on both the asset side and the liability side of the balance sheet. Leases of intangible assets and biological assets as well as oil and gas exploration leases would have been exempted from the new standards. Briefly put, a lessee would record a “right of use” asset and a liability for the obligation to make lease payments. At the inception of the lease, the asset and liability are equal and represent the present value of future lease payments over the term of the lease, discounted using the lessee’s incremental borrowing rate or, if it can readily be determined, the rate the lessor charges the lessee. Under the Exposure Draft, the discount rate used at the inception of the lease (other than a lease whose rent is tied to a fluctuating interest rate) is fixed for the entire duration of the lease, regardless of changes in the lessee’s incremental borrowing rate.

The FASB/IASB decision to identify two types of leases signals a return to operating lease treatment for certain leases. For those leases that are considered “finance leases,” profit and loss recognition would proceed in accordance with the ED. However, for “other-than-finance leases,” such profits and losses would be recognized in a manner consistent with U.S. GAAP and International Financial Reporting Standards (IFRS) (recognition on an income statement rather than a balance sheet). The staff for the boards has been charged with establishing indicators of the two types of leases and performing targeted outreach on this issue. Since the decision includes reference to IFRS and terminology from International Accounting Standard (IAS) 17, the ultimate outcome will likely include attributes of IAS 17, and preservation of the bright lines of FAS 13 remain in doubt. Nevertheless, the boards’ decision to continue a bifurcated approach to the classification of leases is a welcomed sign to many users of leases, in particular retail users.

Lease Term

The length of the lease (and hence the number of rent payments to be discounted) is a threshold question. Under the ED, the term is defined as the longest possible term that is more likely than not to occur. Accordingly, a lessee would have to evaluate the likelihood that it will exercise any renewal terms, and if the exercise of a renewal option is more than 50% probable, that renewal term will be treated as part of the lease term. As a result of the boards’ decision, the lease term for lessees (and lessors) will be the “non-cancellable” lease term plus extension periods when there is a “significant economic incentive for an entity to exercise an option to extend the lease” or for an entity not to exercise an option to terminate the lease. The boards recognized the difficulty created by the ED for parties to estimate at the inception of a lease the likely outcome of an option years down the road. Rather than a greater than 50% probability, lessees will be required to recognize an extension or renewal period only at the point, if ever, where the economic incentive to exercise such option reaches near certainty. Also of note, the boards eased auditing requirements by requiring that the term of the lease be reassessed only when there is a significant change in factors rather than at the end of each reporting period.

Contingent Rentals

Under the ED, contingent rents, escalating rents and percentage rents, as well as fixed rents, would have been counted in determining the asset and the liability. Such assessment would require a number of predictions about future contingencies, inflation rates and sales. If the predictions used in the initial creation of the asset and liability proved materially incorrect, a recalculation of those values would have been made. The boards tentatively agreed that recognition of contingent lease payments by parties should be made if based on an index or rate, such as a price index or market rate, and if payment thereof is “reasonably certain.” Also, the boards clarified that payments under residual value guarantees should be recognized if they are “expected to be payable.” The decision is subject to the caveat that the boards will continue discussions on this point at future meetings.

Strategic Considerations

Prior to the recent board decisions, lessees under traditional operating leases would have been faced with both issues and opportunities if the Exposure Draft were adopted by FASB without modification. Now, lessees and lessors find themselves in a waiting period. The publication date for final standards for the joint lease project is still estimated by FASB to occur in the second quarter of 2011 but the breadth of such recent decisions coupled with the need for further input from staff and future discussions at board meetings leave such timing in doubt. For now, many in the leasing industry are buoyed by the pragmatic approach being taken by the boards and their respective staff on the very complex issue of lease accounting.

Even during this period of uncertainty, there are steps that would be prudent for lessees to take. The first is to review financial covenants in senior loan agreements and bank lines, and open a dialogue with those lenders to pave the way for adjusting the covenant package to reflect the increased liabilities that are likely to appear on the balance sheet. One choice would be to create non-GAAP financial statements for covenant compliance purposes, simply omitting both the right of occupancy asset and its related liability, that would permit the existing covenants to remain essentially as written. Another choice is to come to grips with the differential in amortization of the asset and related liability over time, and craft covenants that permit the imbalance.

The second is the lease versus own decision. If a company is already the lessee under a large number of leases, the housekeeping hassle of the new rules—including determining which leases qualify as “other-than-finance leases”—will be unavoidable. If the company has very few leases, the cost of accounting for new leases may become a legitimate consideration in opting for other financing solutions of capital assets at least if this “other-than-finance leases” characterization is difficult to achieve.

To the extent off balance sheet treatment may no longer be available, that is no great loss. Companies didn’t enter into operating leases for financial engineering purposes in the first place, and investors always took into account the footnoted liability under non-cancelable leases. If all companies have to show leases on their balance sheets, there is no relative reporting advantage for an operating lease lessee compared to a capital lease lessee.

Other benefits of leasing remain untouched by the proposed changes in accounting rules: the higher proceeds in monetizing capital assets through a sale leaseback compared to a secured loan, the absence of financial covenants that may not parallel those of a company’s senior debt, and the ability (for tax purposes) to deduct “average rent” while paying below average in the early years of a lease. And having a right of occupancy asset as opposed to depreciated plant and equipment on the balance sheet is desirable in terms of not becoming an inviting take-over target by raiders who would break up the company to sell off the perhaps appreciated tangible assets at a price in excess of their book value.