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Unclassifying Leases: A New Framework for Lease Accounting

By Peter Eames, BPM Manager
October 20, 2010


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Everybody loves an operating lease. In return for properly structuring a lease and tracking a deferred rent liability, you can keep that lease obligation off of your balance sheet, relegated to a lonely footnote. You can also forgo any unpleasant present value calculations and leave most contingent rents and renewals to be dealt with as they come up.

Well, everyone but the FASB and IASB, that is.

On August 17, 2010, years after the FASB first acknowledged the need to reassess the current accounting for leases, it and the IASB issued a joint exposure draft, Leases, creating a new accounting framework for both lessors and lessees. Besides eliminating operating lease accounting and thus bringing all manner of leases onto companies’ balance sheets, the proposed framework comes with a slew of other changes, not simply limited to accounting entries. Companies most affected are those with many leases, such as retail companies.

The changes are expected to impact expense classification and timing, deferred taxes, balance sheet presentation, key financial metrics, and can potentially even lead to covenant non-compliance for some companies. Given the need for changes in accounting systems and internal controls, as well as no grandfathering on existing leases, compliance with the updated accounting guidelines may involve a substantial amount of time and effort in advance of the effective date, which has not been specified.

Changes to Lessee Accounting

The basic tenets of the exposure draft for lessees is that the lessee should recognize an asset for the “right-of-use” of the leased property and a liability for the “obligation to pay” under the contract. As time passes, the right-of-use asset would be depreciated, generally on a straight-line basis, while interest would be accreted on the liability balance. Some of the significant accounting changes resulting from this concept are:

  • Initial measurement of the right-of-use asset and obligation to pay liability would be the present value of the amounts expected to be paid over the lease term.
  • Regular evaluation of right-of-use assets for impairment.
  • The term of the lease would be the longest term that is more likely than not to occur, potentially leading to longer lease terms for accounting purposes than under current guidance.
  • Present value interest rate would generally be the lessee’s incremental borrowing rate, consistent with other present value measurements.
  • Estimates of contingent rental payments, including percentage of retail rents, would need to be included in the initial measurement of lease related assets and liabilities.
  • Continual reassessment of lease term and contingent rents.

While accommodating these changes will require significant effort, the indirect impacts may be a better reason to proactively address these coming changes.

Some of the indirect impacts include:

  • Elimination of rent expense from the income statement.
  • Increase in EBITDA as both the amortization and interest expense which replace rent expense are backed out of the calculation.
  • Higher expense early in the lease term, with decrease over time, due to lower accretion of interest expense as lease liabilities are paid down.
  • Changes to various metrics used to measure performance and ability to service debt, such as debt/equity, return on assets and interest coverage.

As form follows the changing incentives, there is no doubt that we will see substantial change in the form of leases over the coming years.

Changes to Lessor Accounting

While not initially in the scope of the Boards’ project, the Boards also addressed accounting by lessors and sublessors. This has generally garnered less attention than the changes to lessee accounting as it doesn’t impact nearly as many companies, but the changes are also substantial.

Lessors will be required to take a performance obligation approach in cases where they retain exposure to risks associated with the leased asset. The receivable under these leases would be accompanied by a liability for the obligation to allow the lessee to use the asset, and the lessor would continue to carry the asset on their books. Lease income would be recognized as the lease obligation is reduced over the term of the lease. In contrast, for circumstances where the risks associated with the leased assets is not retained, a derecognition approach would be applied. In these circumstances, revenue would be recognized at inception of the lease, along with a lease receivable. The asset would be removed from the books and recorded as cost of revenues.

Similar to requirements for lessee accounting, lessors would record lease receivables at present value, as well as measuring the lease term as the longest possible lease term more likely than not to occur. Like lessees, lessors will also have to account for contingent rents and residual value guarantees at inception, but only to the extent that they are reliably measurable.

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From a perusal of the comment letters received so far, it is clear that a lot of constituents are not too fond of these proposed changes. For companies with even a moderate amount of lease activity, trying to manually determine the appropriate accounting could quickly overwhelm even the most experienced spreadsheet jockey. However, there is also little doubt that present lease accounting has been a bastion of bright lines and led to substantially different accounting for economically similar transactions. While some changes may come out of the present comment period, it certainly seems that these bright lines will soon be a thing of the past.


This publication contains information in summary form and is intended for general guidance only. It is not intended to be a substitute for detailed research nor the exercise of professional judgment. Neither BPM nor any member of the BPM firm can accept any responsibility for loss brought to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor.