For more than two years, the two major accounting standards boards, the Financial Accounting Standards Board and the International Accounting Standards Board, have been working together to rewrite the rules for real estate and equipment lease accounting in the United States. The intent is to align U.S. lease accounting with international practices and to ensure that assets and liabilities arising out of lease transactions are fully recognized in an organization’s financial statements. The argument for making the changes is that leases represent a significant liability, and this liability should be recognized on the organization’s balance sheet.
Today the vast majority of leases are classified as operating leases. Under the proposed changes, all leases would be treated as capital leases. Understanding why this change is significant requires some background.
In the United States under current accounting standards, leases are characterized as either operating or capital. With an operating lease, rent expenses are written off in the year they occur and appear on the organization’s income statement as an operating expense to arrive at net operating income. The income statement more or less reflects cash flow.
By contrast, a lease is classified as capital if it meets any one of the following criteria:
- The lease transfers ownership to the lessee at the end of the lease term.
- The lease contains an option to purchase property at a bargain price.
- The lease term is equal to 75 percent or more of the estimated economic life of the property.
- The present value of the minimum lease rental payments is equal to 90 percent or more of the fair market value of the leased property.
A capital lease is treated like a purchase of property with 100 percent financing. The lease value is capitalized and appears as a balance sheet asset, with a corresponding "capital lease obligation" that appears as a liability. Both asset and loan are amortized over the life of the lease, although not at the same rate, and payments are split into interest payments and principal reduction.
Under a capital lease, net operating income increases, since there are no rent payments, but depreciation and interest expenses increase and net income before tax decreases. Interest expense will be greatest in the earlier years and will fall as the lease ages, as with a mortgage. As a result, net income before tax will be most adversely affected in the earlier years and will rise as the lease ages.
What does this mean for businesses? The most significant changes will occur to the balance sheet, with the addition of the capitalized lease as an asset and its corresponding liability. How these changes will impact ratios that measure the effective use of capital and indebtedness is what concerns both the real estate industry and many businesses. With few exceptions, return on assets and return on investment will decrease, and debt-to-equity ratios will increase, sometimes exponentially.
The scale and significance of these changes will vary from organization to organization, depending on a variety of factors. For privately held firms that generate capital internally and seldom need to seek outside capital, the impact may not be significant. Firms that already own much of their real estate, as many manufacturers do, may not see a serious impact.
However, for retailers, service providers and other businesses that lease multiple locations, the impact could be huge. The annual report for one such national retailer/service provider reveals that it has operating leases with current annual rents totaling $1.4 billion and a capitalized value exceeding $12 billion. The proposed change would increase this company’s long-term debt by 20 percent overnight.
Some tenants faced with the need for a long-term lease might now take a closer look at outright ownership, as the capitalized lease cost approaches the impact of ownership.
While it seems fairly certain that the proposed rule changes will take effect, many questions remain. What’s clear is that it will require a great deal of work to incorporate the new rules into organizations’ books, both to begin the process and each year thereafter to update the calculations.
Gregg Bryant is vice president of the Cabot Group.
3/23/12 (c) 2012 Rochester Business Journal. To obtain permission to reprint this article, call 585-546-8303 or email firstname.lastname@example.org.