The Financial Accounting Standards Board (FASB), together with its counterpart in international accounting, the International Accounting Standards Board (ISAB), has recently issued a Discussion Paper on accounting for leases by lessees. If the proposed standards are adopted, the existing classification of leases as either operating or capital (i.e., financing) will no longer exist – all leases will be capital leases. Lessees’ contract rights will be recorded on balance sheets as assets, and the present value of their lease obligations will be recorded as liabilities. The new standards will apply to all leases, whether for real property or for personal property such as machinery.

The Disclosure Draft does not address the effect of the proposed changes on the tax treatment of leases. It is possible that such treatment will be addressed in the comment letters and the exposure draft.

Although the Discussion Draft has a chapter discussing lessor accounting, it states that the Boards (that is, FASB and ISAB) are deferring consideration of lessor accounting for a number of reasons, including that the current accounting standards for lessors raise fewer issues than those for lessees, and consideration of new standards for lessors may cause delays in issuing new standards for lessees.

After receipt of comments on the Discussion Draft (due July 17, 2009), the Boards will prepare and distribute an exposure draft, which they have indicated will be published by 2010. The final rules could be effective for financial statements as early as calendar 2012. A copy of the Discussion Draft can be obtained by emailing fasbpubs@fasb.org.

The effects of the proposed changes as well as implications for changes in accounting rules generally are discussed in the final two sections of this article.

 Reasons for the Proposed Changes

The Discussion Draft states that the present lease accounting model has been criticized (by the Securities and Exchange Commission, among others) for failing to meet the needs of users. Among the reasons cited are:

 (a) Many users believe that operating leases give rise to assets and liabilities that are not recognized under present standards, and the information available in the notes to financial statements is insufficient to permit those users to make the necessary adjustments.

(b) The existing standards provide opportunities to structure transactions so as to achieve a particular classification – if the lease is classified as an operating lease, the lessee obtains a source of unrecognized financing that can be difficult for users to evaluate.

(c) The existing standards are complex and do not definitively distinguish between capital and operating leases, leading to subjective judgments that result in similar transactions being accounted for in different ways.

Proposed Change

Under the Discussion Draft, lessees would be required to treat all leases as capital leases using the “right to use” method. Under thismethod, a leased asset is an asset and the obligation to make lease payments is a liability. The asset and liability are to be recorded at the lessee’s cost, determined by calculating the discounted present value of the lease payments using the lessee’s incremental borrowing rate (that is, the rate at which the lessee would be charged to borrow, for the same term and with the same security, to purchase the asset being leased) and not the interest rate implicit in the lease.

On certain specific lease issues, the Discussion Draft provides that (i) the Boards have not reached a preliminary view as to whether the proposed standards should apply to short-term leases; (ii) the term of a lease with options is the “most likely” term (that is, it is likely the option will or will not be exercised) subject to reassessment at each reporting date; and (iii) whether to include contingent (e.g., percentage or indexed rental) payments depends on whether such payments are likely or not, subject to reassessment at each reporting date.

Effects of the Proposed Changes

If the proposed standards are adopted, they will affect the financial statements of all companies with leased assets. The Discussion Draft does not propose that leases existing at the time of adoption be “grandfathered.”

Some of the effects of new standards will be:

 (a) Companies that utilize operating leases will see their balance sheets change dramatically – assets and liabilities will increase, the latter by a larger amount because assets will be based on the discounted values of all future payments. In that such discount rate is a lessee’s incremental borrowing rate, otherwise identical leases may result in different asset and liability values for different lessees.

(b) The inclusion of lease assets and liabilities may affect the calculation of financial ratios included in many common financial covenants, among them debt to total-assets and fixed charge coverage ratios.

(c) Since “rent” will not exist, what are now operating leases will be accounted for by lessees in a way similar to installment loans, separated into interest expense and depreciation, affecting return on assets, debt to equity ratios and calculations of leverage.

(d) There will be added complexity and cost in preparing financial statements because, for example, if lessees have options, companies will have to estimate likely lease periods and asset and liability components of leases at each reporting date.

(e) The calculation of EBITDA will significantly change; it will be higher because there will be no charge for “rent” expense, and “interest” and “depreciation,” though increased by the amount of excluded rent, will continue to be excluded.

(f) The change in calculation of EBITDA could alter the amount of bonuses, commission compensation or earnout payments that are linked to EBITDA or some variant of net income, even though the company’s cash position has not changed.

What to Do Now

Although the adoption of new standards will not occur for a while, it would be prudent for companies to consider consulting their accountants and attorneys as soon as possible to determine the impact of these changes.

 As noted above, the change in lease accounting will affect financial statements, which in turn will affect whether covenants are met in a variety of agreements such as loan agreements, compensation agreements, and leases with percentage or indexed rent provisions.

Over the course of a year, there are many changes in GAAP rules such as those described in this article. Some have little effect on contractual rights and obligations built into agreements, but others may seriously affect the expectations of the parties.

The problems can be mitigated and perhaps eliminated if agreements contain a saving provision that requires the parties, at the request of either, to amend them so that the financial terms are altered or are interpreted to have the same economic effect as if the accounting change had not occurred.

Many agreements do not contain such a provision. It is essential that lessees and their counsel conduct a prompt review of their agreements containing financial covenants or representations to assess the need for such a provision and to seek to amend the documents as necessary. Amendments should cover not only changes in lease accounting but all changes in accounting principles. The other parties to such agreements should anticipate requests for such an amendment.