When Is a Lease a Lease?

The answer will prove pivotal to companies' balance sheets when a new lease accounting standard comes out.

A revamped lease accounting standard in the works will likely put hundreds of billions of dollars in assets and obligations onto some companies’ balance sheets. That has had companies that will be most affected by the changes — such as airlines, retailers, and railroads — dreading any progress the rule-makers might make in creating a new standard. And executives of those companies have been pushing for the United States and international accounting boards not to apply the new rule to all leases.

Businesses may have gotten at least part of their wish, if the decisions made at a recent joint meeting of the Financial Accounting Standards Board and the International Accounting Standards Board are any indication. In one of the latest agreements made in the boards’ glacial move to overhaul the existing lease accounting rules, FAS 13 and IAS 17, they have chosen to exclude some leases from a final new standard.

But since the boards have yet to explain how companies will know which leases will be exempted, it’s too early to tell how much of an impact this change could have on the effects of the new rule, which won’t be ready until at least 2011. It’s also too early to know whether it will lead to the restructuring of how current lease agreements are arranged.

After all, the standard-setters must tread lightly to avoid creating a new standard with defects that are similar to those critics have cited in the one U.S. companies have been following for 35 years. A particular concern about the current rule: bright-line rules can result in the structuring of leases to inaccurately reflect a company’s assets and liabilities.

Under the current rule, standard-setters believe, companies have been reworking leasing agreements to have them fall under the “operating lease” classification. In 2005 the Securities and Exchange Commission staff estimated that in this way, publicly traded companies are able to hide $1.25 trillion in future cash obligations. For example, as IASB chairman David Tweedie has noted, airlines’ balance sheets can appear as if the companies don’t have airplanes.

That could change under the new plan. Companies would have to capitalize assets that have traditionally fallen under the operating-lease classification. The result: companies that lease would appear more highly leveraged.

Earlier this year, FASB and the IASB released a paper outlining their initial thoughts on the plan, and they expect to propose a standard next year. But they’re still ironing out the details and have met six times so far this year on the subject. They have only recently begun deliberating how lessors will fit into this new regime.

At least one item they have agreed on: the premise. Rather than distinguish between capital and operating leases, companies should think about their “right to use” a leased item, whether it be plants, property, or equipment. Lessees will record that right as an asset and their obligation to pay future rental installments for that item as a liability.

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