Taking the “Ease” Out of “Lease”?

By doing away with operating leases, new accounting rules could bring billions of dollars back onto 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.

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