Leases Headed for the Balance Sheet

The upcoming joint FASB/IASB exposure draft on lease accounting will put an end to off-balance-sheet treatment for leases, while throwing in some n...
Marie LeoneMay 27, 2010

Equipment leasing is finally on the upswing. The volume of new commercial-equipment leasing rose 15% in April, compared with the same period in 2009. That’s the first year-over-year increase seen in the $518 billion equipment-finance market since July 2008, according to the Equipment Leasing and Finance Association, which released its latest data on Tuesday. Month-to-month volume was up too, rising 9% to $4.7 billion. The uptick is “a positive sign that businesses are starting to invest in capital assets,” says ELFA president William Sutton.

But while the rising tide is welcome, accounting for leased equipment, as well as leased property, may soon become more complicated. The Financial Accounting Standards Board and the International Accounting Standards Board are rewriting the rules on lease accounting, and the exposure draft of their converged standard is scheduled to be released in June. The project is a contentious one: based on their reading of the preliminary discussion paper, finance executives have described the proposed new rules as “onerous” and “complex,” two traits that the standard-setters have worked hard to purge from accounting rules as they rewrite them.

The new standard will replace FAS 13 in the United States and IAS 17 in countries using international financial reporting standards. Essentially, it erases the distinction between operating and capital leases and pulls all leases back on the balance sheet, says Jay Hanson, national director of accounting at McGladrey & Pullen.

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The proposal does this by eliminating the so-called 90% rule. Currently, if the present value of lease rental payments amounts to more than 90% of the asset, the contract is considered a capital lease and the asset and liability are placed on the lessee’s balance sheet. If the payments amount to less than 90% of the asset’s value, the lease is considered an operating lease and the lessee simply records the payments as expenses on the income statement.

(Lessor accounting rules will also be addressed in the exposure draft, but it is unclear what changes to existing rules will be presented, as the boards were handling lessee and lessor accounting separately during deliberations.)

“In one sense, some parts of this project make the accounting easier,” comments Hanson, because companies won’t have to spend time figuring out if a transaction is an operating or capital lease. But then, he adds, complexity “creeps in.”

Complication No. 1: Renewal Options

Lease renewal options are one area of contention. Under existing rules, a company uses the minimum lease payment to calculate the present value, and posts that number to the balance sheet. However, under the proposed rule, management must make a judgment regarding what is the most “likely” lease term, and that means considering any renewal options attached to the lease. Since companies negotiate such options because they are unsure of what they will be doing at the end of the lease term, that uncertainty would now have to be factored into assets and liabilities that wind up on the balance sheet, points out Mindy Berman, managing director of corporate capital markets at Jones Lang LaSalle, a real estate service provider.

Consider two retailers in the same mall with identical leases. The “subjective” nature of the draft rule means that each retailer could be capitalizing different amounts, says Berman. In her view, that distorts comparability rather than providing better visibility into lease transactions, which is one of the stated purposes of rewriting the rule.

Hanson says the renewal provision is “controversial” because companies are putting a liability on the books for something they are not contractually obligated to accept. Under the proposal, he explains, a company that agrees to a 10-year lease with a 5-year renewal option would have to show the asset and liability related to a 15-year lease if management thought it was likely the company would renew after a decade. The intent is to “portray the best shot at economic reality,” he says, but the draft rule “adds complexity” because it is asking companies to make an up-front judgment about the future. (Further complicating the valuation is the proposal’s mandate that the lease estimate be remeasured every reporting period.)

Such future vision may not be a problem for a manufacturer with a single facility, but for companies with a substantial leasing portfolio, the financial modeling could be burdensome. In a comment letter on lease accounting sent to FASB and the IASB, Devin Ozan, controller at McDonald’s, said the fast-food giant would incur “significant personnel costs” on an ongoing basis, “as judgment and insight would need to be applied to update estimates for our leases.”

McDonald’s also has “significant concerns” with respect to remeasuring rental payments every reporting period, wrote Ozan, noting that material changes are triggered much less frequently “than quarterly or annually.” Typically, McDonald’s tries to secure 20-year leases to match its conventional franchise arrangement, according to Ozan.

Complication No. 2: Contingent Rent
More complexity relates to estimates of contingent rent. Contingencies associated with real estate leases include, for example, payments tied to a percentage of sales or the Consumer Price Index. Witness a company that includes a percentage of monthly sales in its rent payment. Under the draft rule, the company is required to forecast what its sales will be over the lease term, apply to that the agreed-on percentage, and put that total on the balance sheet. Making accurate sales forecasts is challenging, notes Berman.

In his comment letter on the proposal, JC Penney controller Dennis Miller said contingent rent should not be included as part of a lease obligation. Contingent rent was never a “significant item” for the retailer, he wrote, and is not expected to be one in the future. “Including a contingent rent assumption would add a great deal of complexity and the effort required would outweigh any benefit to be derived from its inclusion,” stated Miller.

Despite companies’ complaints about the difficulty of calculating lease contingencies, some experts believe the numbers already exist in corporate financial systems. “Many companies already have this information, as it is often used for internal budgeting and forecasting purposes, especially if they’ve entered into contracts with contingencies and extensions,” says Barbara Davidson, a technical manager at the IASB. Nevertheless, she appreciates that some companies may have to revisit internal systems and processes to fine-tune the data for financial reporting if the proposed rule is issued in its current form. “For companies with a large number of leases, management will have to consider how to include this information as part of their regular reporting processes,” she adds.

A Trillion-Dollar Adjustment?

Berman of Jones Lang LaSalle notes that the investment community has long taken off-balance-sheet leases into account when evaluating a company’s risk profile. Rating agencies have always treated leases as capital items and adjusted a company’s leverage accordingly; banks have done so, too. Still, the proposed standard is likely to affect thousands of companies around the world. Many companies “will have to adjust their business models to come to grips with the new rules,” says Hanson.

Although FASB and the IASB haven’t finalized the transition guidance or effective dates of the proposed rule, there are indications that it will apply to existing leases. That could eventually force lessee corporations to capitalize more than $1 trillion worth of operating leases. In a 2005 report, the Securities and Exchange Commission estimated the value of operating leases held by U.S. publicly traded companies to be $1.3 trillion, notes Berman. That number is likely much higher today, she says, considering the number of private-company leases that are not reported publicly and the general growth in the real estate and equipment leasing markets.