Changes on the Horizon for Lease Accounting

Brad Netzel, CPA   email
Auditing & Accounting Senior Manager
October 2010

The days of creatively structuring lease agreements to keep them off the balance sheet will likely be coming to an end within the next year or two.  With the newly proposed accounting standard on leases in the comment phase and anticipated to be released during 2011, lessees and lessors will be required to include an asset and liability on their balance sheets for each leased asset.  Since the transition to the newly proposed accounting standard could require restatement as of the beginning of the earliest year presented to maintain comparability, it will be important for businesses to plan ahead for this change.

What are the significant changes?

When looking at the proposed standard, there are a fair number of changes that will need to be understood to ensure you are properly accounting for your lease agreements; however, here are a few of the more significant changes.

• Presentation:  New guidance will require a lessee to record a "right-to-use" asset and a lease liability on the balance sheet. Any payments related to the lease liability will be shown as a cash outflow from financing activities on the statement of cash flows.  Lessors would need to follow the performance obligation approach or the derecognition approach depending on the level of risks or benefits retained by the lessor.
• Lease term: The lease term will be evaluated under a "more-likely-than-not" standard to determine the most likely outcome with regards to lease extension options or other renewal features within the lease.
• Minimum lease payments: The minimum lease payments will be calculated using a probability-weighted cash flow analysis of a reasonable number of scenarios and include an estimate of any contingent rental payments.  Updates for actual experience will be required to evaluate the carrying amount of the recorded liability.

What do I do with existing leases?

Existing leases will need to be recorded on the balance sheet by calculating the present value of the remaining minimum lease payments using the lessee's incremental borrowing rate at the date of initial application of the new standard.  The date of initial application would be the beginning of the earliest period shown. 

How does this affect your business?

While the underlying business decisions should not be impacted by the proposed accounting standard, there are some critical items to plan for to avoid issues once the guidance is effective.

• Lease structure: Since all leases will be reflected on the balance sheet, business owners should be changing their mindset away from the structure of the lease toward obtaining the highest value for the business.  This could simplify lease agreements since complex lease structures will no longer keep the asset and liability off the balance sheet.

• Documentation requirements: Additional processes may need to be established to ensure all leases are captured.  Also, the level of judgment in valuing the asset and liability may require more detailed analyses and documentation compared to the old "bright line" rules for determining lease classification.  Inaccurate estimates could lead to significant true-up adjustments at year end. Without proper support, audit or review procedures could take substantially longer to complete, resulting in increased compliance costs. 

• Financial statement metrics: Financial statement ratios will be impacted, along with debt covenants that are dependent on certain financial measures.  You should work with your creditors to determine the need to modify existing debt covenants to levels that will be meaningful after the application of the new standard.

In preparation for these pending changes, it's important to (1) plan ahead to avoid costly, time-consuming delays, (2) educate employees as to the proposed standard, and (3) discuss potential impacts on debt covenants with your creditor.  You will need information sooner than you think given the comparative presentation requirement.  This information will be easier to gather now compared to trying to recreate it 12 to 24 months later.  By planning ahead, you should be well on your way to efficiently and effectively complying with the proposed accounting standard.

If you have any questions regarding the upcoming changes, please contact Brad Netzel at 262/754-9400 ext. 371 or bnetzel@kolbco.com.