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By doing away with operating leases, new accounting rules could bring billions of dollars back onto balance sheets.
Marie Leone, CFO Magazine
December 1, 2010
Accounting-standards setters are under fire, again. The new leasing standard, proposed jointly by the Financial Accounting Standards Board and the International Accounting Standards Board, has been characterized as naïve, lacking value, and in need of serious reevaluation. The outcry comes not from a handful of opponents but from companies on both sides of common lease contracts — those that rent office space, copiers, or airplanes and those that own the assets.
At the center of the maelstrom is the "right-to-use" asset concept, the accounting mechanism that places leased assets and liabilities on the balance sheets of lessees, as if they owned the assets. That would essentially eliminate operating leases. Credit Suisse estimates that, within the S&P 500 alone, the volume of assets returning to balance sheets could surpass $550 billion.
At those levels, asset ratios could be thrown out of whack, potentially sending debt covenants — if not adjusted — into default, says Ross Prindle, a managing director with Duff & Phelps, while also requiring banks to increase their regulatory capital and wreaking havoc on compensation plans tied to the asset measures.
In addition, the proposed standard (called Topic 840 by FASB) requires lessors to recognize assets and liabilities in a new way. A lessor must recognize an asset as representing its right to receive lease payments and, when appropriate, record a liability as representing the contractual right of others to use their equipment or real estate.
Then, based on how much residual value the lessor estimates it will retain at the end of the lease, it must also use one of two accounting approaches laid out in the draft: either the performance obligation or the derecognition model.
If the rules seem complicated, that's because they are, says D.J. Gannon, a deputy managing partner with Deloitte. However, he says the proposed changes are well intentioned: rulemakers want to curb abusive leasing practices by companies that structure around the 90% ownership test that currently determines whether a contract is an operating lease and can therefore be removed from their balance sheets.
Be that as it may, in the year-plus since FASB issued its first discussion paper on the topic, more than 300 comment letters have been submitted, most indicating that stakeholders are not convinced that the intended benefits will be worth the additional cost and effort.
The comment period is open until December 15, and two days later FASB and the IASB will hold the first of four new "outreach" meetings to get a better handle on what worries constituents. The boards plan to release a final rule during the first half of 2011.
Lessor Has More
What's interesting is that most critics are less concerned about the concept of capitalizing all leases than with how FASB and the IASB propose to treat the leases after bringing them back on balance sheets.
"The board is naïve if they don't think the same kind of structuring will occur under these rules as exists with the bright-line test," asserts Shawn Halladay, a principal at The Alta Group, a leasing-industry consultancy. Halladay says that lessees have only to structure leases for shorter terms to push more of the asset value from their balance sheets. That's because shorter-term leases require the lessor to retain a larger portion of the asset's residual value.
Lessor accounting gets more complicated if the company retains a "significant" amount of the asset's risk or benefit. At that point, a lessor is required to use the performance obligation approach, which forces the company to carry both the asset and the total lease payment receivable (at the receivable's present value) on its balance sheet, as well as a performance obligation liability. In contrast, current capital lease rules require the lessor to carry a lease payment receivable on its balance sheet, but not the underlying asset.
The other accounting model available to lessors is the derecognition approach, which is used when the lessor retains a low residual value on the asset. The impact of the two-method treatment is sure to create "a greater divergence in practice among lessors," says Michael Fleming, also a principal at The Alta Group.
Lessors that hold real estate for investment — most notably in real estate investment trusts — may get a chance to avoid leasing rules completely, says Mindy Berman, managing director at Jones Lang Lasalle, a real estate services firm. Soon FASB will issue a proposal that requires real estate investment holdings to be measured at fair value, testing periodically for impairment, instead of following lessor accounting rules.
No Term Limits
Renewal options get sticky under the proposal. Each lease with an option must be evaluated by both lessees and lessors to determine the most likely renewal scenario, and those extra years must be added on to the lease term. That means that a 10-year lease with an option to renew for 6 years becomes a 16-year lease if it is likely the renewal option will be exercised. Lessors and lessees on either side of the same contract are "almost guaranteed" to come up with different lease terms based on renewal options, says Halladay.
More troubling, the extra years that do not reflect the legal lease obligation could prove costly, asserts Bill Bosco, who consults for the Equipment Leasing and Financing Association and sits on the International Working Group on Lease Accounting for FASB and the IASB. In the hypothetical example, the entire 16 years worth of assets or liabilities is dropped onto lessee balance sheets, even though the lease agreement stipulates 10 years.
The 16-year term could look even worse to lessees because the draft rule, if adopted, appears to front-load rent expense by switching the accounting from booking a rent expense to splitting the payments into two streams, amortization expense and interest expense, says Morris Oldham, a partner with McGladrey. This change affects the timing of the lessee's recognition of expenses, because it could work like a typical mortgage with imputed interest. That means the interest expense is higher, and represents the bulk of the lease payment, in the early years of the lease term. In addition, if a renewal option turns a 10-year lease into a 16-year obligation, the lessee has 6 more years during which the lease will have an accounting impact on operations.
Contingent rents, which are lessee payments frequently tied to some variable, such as a percentage of sales or the consumer price index, would impose another burden. Contingent-rent estimates have to be updated at each quarterly measurement date, or sooner if a material change is booked. "There is a lot of look-back about what to put on the balance sheet after the initial measurement," says Prindle, who expects real estate leases to be particularly troubling.
Judging from the draft, "FASB really does not understand what commercial tenants do," insists Marisa Manley, president of consultancy and broker Commercial Tenant Real Estate Representation. She says the proposed rules may "fundamentally change the way tenants look at leasing…and change the relationship between tenants and landlords," especially regarding the buy-versus-lease decision.
If the draft rules remain unchanged, she says, several things will result. First, the typical lease contract will drop from its current 10-year term, as the opportunity to amortize payments in a straight-line manner is abolished and expenses are front-loaded. And tenants will be far more careful about renewal plans, since any indication of reupping a contract would trigger a lease-term extension for accounting purposes and a longer payment obligation carried on the balance sheet. Shorter-term leases may also prompt landlords to charge higher rents, Manley says, since the stability of a long-term commitment is gone.
But the rules will have lessees scrutinizing real estate costs, and that could be beneficial because some landlords use gross payments — bundled real estate and service fees — as a profit center. (Landlords have been known to charge a 300% premium for late-night air conditioning and heating.) Still, the concern for most tenants will be trying to determine if they are in a position to abandon leasing in favor of buying.
Cash Flow Redefined
Lessee cash-flow statements will also be affected. The draft rules require lessees to classify cash payments as financing activities, rather than payables that run through operations. So, while the net effect is that actual cash flows remain the same, the accounting entry "cash flows from operations" could be affected, says Gannon, again disrupting ratios that are used to measure performance or access capital.
In addition, Oldham thinks that shifts in income could ultimately affect debt service coverage ratios, depending on the multiple of operating income and the definition of operating income written into a lending agreement. If a decline in income during the early part of a lease causes a debt ratio to sink too low, albeit temporarily, the company will have to make up the income somehow if it wants to maintain proper ratio levels.
The front-end loading of the lease expense could also result in lopsided reporting for some lessees. Bill Bosco calculates that by eliminating the straight-line method and replacing it with amortization and imputed interest, a hypothetical lessee would see expenses climb by 21% in the first year of a 10-year office lease (see related examples above). In the first 5 years of that same lease, the expense would be 63% higher than current generally accepted accounting principles.
Marie Leone is senior editor for accounting at CFO.
What motivates companies to lease? "Cash flow, taxes, convenience, and off-balance-sheet accounting treatment," says Michael Fleming, a principal at lease-financing consultancy The Alta Group. Traditionally, protecting cash flow has been the primary reason for leasing, since a company can use a leased asset to generate revenue with no money down, and pay for it over time. The lessee may also be able to take advantage of tax breaks in the form of lower lease payments, if the lessor has enough net income to capture tax breaks from expensing or depreciation, adds Fleming. The convenience of leasing equipment quickly, and not having to worry about certain maintenance issues, has always attracted smaller, less-capitalized businesses to leasing, and off-balance-sheet treatment of assets has been viewed as a benefit to some companies, although it has never been a prime motivation, contends Fleming.
Many times, companies that claim they are looking for off-balance-sheet treatment are really just looking for lower lease payments, "so it is truly a cash-flow issue," insists Shawn Halladay, also a principal at The Alta Group. The confusion exists because lower lease payments are often the result of a lessor creating a higher residual value, which may take the asset value off of the lessee's balance sheet. — M.L.