Operating Leases May End Up On Your Balance Sheet

by Alicia Rader, CPA and Tim Ayler, CPA | Team Members of the Construction Services Group

Many contractors’ balance sheets will be changing in the next few years due to proposed changes that are anticipated to be made to the way leases are treated for accounting purposes. Currently, many companies lease their building, or large pieces of equipment, under operating leases. Operating leases allow for only the current year expense to be recorded on the income statement, without an impact on the balance sheet. The rules will likely be finalized in 2011, with implementation set to happen sometime later, probably January 1, 2013 or after. Companies may find their assets and liabilities being “grossed up” to account for the changes. This may require some negotiations between contractors and their bank related to their bank covenants, or discussions with their bonding company related to their bonding capacity.

The International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) have been working jointly on changes to how lease accounting would be treated in the future. In August 2010, an exposure draft on leases was published that is moving toward changing the lease rules from their current guidelines under SFAS 13, which was issued in 1976, along with 9 amendments since.

The current lease accounting approach classifies leases as either an operating or capital lease and the lease gets recorded differently based on which type the lease is calculated to be. This has allowed leasing companies to structure leases as operating leases for years, which is beneficial to the lessee. Many users of financial statements have criticized this method of accounting of leases because it gives a false depiction of a company’s liabilities and leasing transactions. Therefore, the proposed approach by IASB and FASB is working to minimize those criticisms and properly reflect assets and liabilities on the balance sheet for most leases. The proposed changes mostly impact companies with leases currently classified as operating, but will still have an affect on companies with capital leases as the accounting for options, contingent rentals, and other variable lease terms is addressed in the new rules.

Under the new accounting rules for leases, lessees and lessors will apply a right-of-use approach to primarily all leases. For the lessee, an asset would be recorded for the lease term of the right-of-use asset and a liability would be recorded at the present value of the best estimate of expected lease payments (including options to extend or terminate the lease). For the lessor, an asset would be recorded as a right to receive lease payments and depending on the exposure to risks or benefits with the leased asset, the performance obligation approach, or the derecognition approach, will be used. The performance obligation approach records a lease liability while continuing to record the leased asset. The derecognition approach derecognizes the rights in the leased asset that is transferred to the lessee and continues to recognize a residual asset representing its right to the leased asset at the end of the lease term.

Although no one can predict how drastic, these new guidelines will have an impact on companies signing long-term leases, or it could encourage companies to own their own building or equipment rather than lease. Sale-leaseback transactions could be considered less desirable if the transaction does not remove the asset and liability from a company’s balance sheet, except for cases where it is more about cash flow.

This is a brief summary of part of the exposure draft on leases. There are certain, less common, leases not covered by the exposure draft. A complete draft with examples can be viewed at www.ifrs.org and people have until December 15, 2010 to make any comments on the exposure draft on the website. FASB and IASB have said their target date for the final standard is June 2011. We will keep you informed of changes in the lease accounting rules as they occur. Please contact us with any questions.