Keep an Eye on Those Leases!

Could a change in lease accounting be on the horizon? While the basic lease accounting model hasn't changed in more than 30 years, it has been the subject of significant criticism for almost as long. At a time when there is a push for more principles-based accounting standards, SFAS No. 13, Accounting for Leases , with its many "bright-line" thresholds that determine lease classification is the example cited most often as reflecting the problem with form-driven rules. The arbitrary "bright lines" in the guidance also allow companies to structure lease transactions to result in operating lease classification. For example, take a look at the financial statements of any airline and you’ll find no airplanes on the balance sheet!

In June 2005, the SEC recommended that existing lease standards be rewritten. In 2006, the FASB and the International Accounting Standards Board (IASB) added a joint project to address lease accounting. A significant step in the FASB/IASB project plan is the issuance of a Discussion Paper, anticipated to be released for comment in March 2009. Based on the Boards' deliberations to date which may be subject to change, the Discussion Paper is expected to propose significant changes to lessee accounting; and the direction of the leasing project is clear. After considering a number of alternative models and debating their relative merits, the Boards have tentatively settled on a “right-of-use model.” This model would require the lessee to recognize an asset representing its right to use the leased asset, and a corresponding liability for its obligation to pay rent. Under the right-of-use model, operating lease accounting under SFAS No. 13 would be eliminated, and lessees would account for all leases in a manner similar to that used for capital leases today.

Although the Boards are sensitive to the cost-benefit considerations for small-dollar and short-duration leases, the Boards have yet to address this concern. The idea that small-dollar leases would be exempt from the new standard is troubling to certain Board members because leases that are individually low dollar may be material when aggregated. Further, it is likely that some type of bright-line threshold would be necessary to implement such an exception. As noted, similar bright lines in the current model have been the target of significant criticism.

The proposed accounting model would have the greatest impact on lessees of significant amounts of "large-ticket" items, such as real estate, manufacturing equipment, power plants, aircraft, railcars, and ships. However, the revised standard would also affect virtually every company, including those who lease computer equipment, copiers, office furniture, and telecommunications equipment. The proposed model would require lessees to remeasure their lease obligation at each balance sheet date based on updated estimates, including the probability of exercising renewal options and the amount of contingent rent that the lessee expects to pay over the revised lease term. The remeasurement of the obligation would be reflected as an adjustment to either earnings or the right-of-use asset, depending on the nature of the change. (This would require significantly more effort compared to the current model where lease accounting is set at inception and revisited only if there is a modification or extension of the lease!) Because these changes may change the economics of leases written in the future, you may need to reexamine "lease versus buy" decisions.

Also, given the long-term nature of many leases and the desire for comparability, it is unlikely that accounting for existing leases will be grandfathered. Accordingly, you should consider the implications of these potential changes as you negotiate long-term leases, even before the effective date of the new standard.

The Discussion Paper is expected to be issued at the end of March 2009, with comments due by July 2009. The Boards will then consider the comments received and continue their deliberations on specific issues, with the expectation of issuing an Exposure Draft of the new standard in the first half of 2010. The Boards expect a final standard to be issued is 2011, although the Boards have yet to discuss the effective date and transition provisions.