New Accounting Rules Could Eliminate Operating Leases

BOSTON—A discussion paper on potential changes to lease accounting was released last month by the US Financial Accounting Standards Board and the International Accounting Standards Board. Comments on the proposed rules are being accepted until July 17, an exposure draft is anticipated in 2010 and final rule issuance could come as early as 2011. But as currently envisioned, one industry expert estimates the changes could see at least $1.3 trillion of real estate and equipment operating leases suddenly capitalized on the balance sheets of public companies in the US.

“The fundamental thing that’s going to occur, if it goes through, is that all leases will be capitalized,” says Mindy Berman, Boston-based managing director in the corporate capital markets group of Jones Lang LaSalle. “There will be no more off-balance-sheet treatment. Operating leases will go away.”

Likewise, the pattern of rent expense will change, since the straight line rent expense reporting of operating leases will no longer apply. Lessees will have to include any lease renewals, contingent rents, purchase options and residual guarantees when estimating the liability of a lease.

The accounting changes, when they are adopted, will affect companies in all industries and of all sizes. “Balance sheets are going to explode,” says Berman.

Capitalizing all of these leases will not only be cumbersome work, but it could affect companies’ existing loan covenants as well as the way analysts and investors perceive their financials and operating performance, Berman adds.

But while it will do away with the off-balance-sheet treatment that has been an advantage of pursuing corporate sale-leasebacks, Berman does not expect the proposed lease accounting changes to be a deterrent to future sale-leasebacks. Those transactions, build-to-suits and net lease arrangements in general are fundamentally decisions about whether or not to own real estate and the best use of a company’s capital, she notes, “but usually accounting is not driving the decision.”

That said, net lease tenants and landlords alike will have to take the new lease accounting regime into account, as they are likely to have structuring implications. “Owners are going to need to understand the implications for their tenants or prospective tenants,” Berman says. And corporate tenants will have to understand, for example, that while they may prefer a short lease term because it would result in less liability on their balance sheet, a landlord may not be able to get financing with that short-term lease. “Capital market realities will dictate how transactions will get done—not accounting rules,” she adds.

The lease accounting project, a joint effort between the two accounting boards, first began in 2006 and has been slowly making its way to the March 19 issuance of the discussion paper. That paper “is a response to concerns raised by investors and other users of financial statements regarding the treatment of lease contracts International Financial Reporting Standards and US generally accepted accounting principles,” the boards say in announcing the release of the paper.

“In the discussion paper the IASB and the FASB discuss a possible new approach to lease accounting,” the announcement continues. “The boards propose that lease accounting should be based on the principle that all leases give rise to liabilities for future payments and assets (the right to use the leased asset) that should be recognized in an entity’s statement of financial position. This approach is aimed at ensuring that leases are accounted for consistently across sectors and industries.”