Do you lease your warehouses or fleets under “off balance sheet” operating leases? Are you considering new lease options as part of your strategic plan? Then you need to be aware of the FASB’s proposed changes regarding lease accounting. This quarter, the FASB is expected to issue an exposure draft of an Accounting Standards Update (ASU) with proposed changes to lease accounting. Gone will be the concepts of a “capital lease” and an “operating lease.” Introduced will be a single lease model that involves recording an asset and a liability on the books of the lessee and lessor for every lease. The lessee will recognize a “right to use” asset and a liability for expected lease payments. The lessor will recognize the leased asset plus the right to receive rentals and a liability for permitting the use of the leased asset.
The purpose of these changes is part of an ongoing project to converge U.S. GAAP with International Financial Reporting Standards (IFRS). These changes will affect many U.S. businesses, notably transportation and logistics companies who lease large fleets and multiple warehouse spaces under current operating leases. The changes should not have a direct effect on cash flows, but will directly affect the balance sheets and P&L’s. Assets and liabilities will be recorded on the balance sheet where previously there were none. What used to be rent expense will be recorded as depreciation and interest (or lease amortization).
There will be several things you need to consider as you evaluate leasing options in the future. Consider the impact on debt covenants that might limit capital expenditures and the effect on certain financial ratio covenants. How long to lease will be an important decision as interest or lease amortization expense will generally be greater earlier in the life of the lease. Renewal and purchase options will have to be considered. Under the proposed standard, a 10-year lease with a 5-year renewal option might require a company to measure the asset and liability on a 15-year basis, depending on the more likely lease term. If a lease has an option to purchase, and the company intends to do so, the lease obligation will include the option purchase price. Internal targets for return on assets or EBITDA will be impacted because of these changes.
The FASB intends to issue this ASU sometime during the first two quarters of 2011. They have not indicated a required implementation date. Transportation and logistics companies need to start considering these effects in their planning now. “Grandfathered” leases are not expected to be allowed under this update. Any leases existing at the time the ASU is effective will still be accounted for under the update. Billions of dollars of lease assets and liabilities will be added to companies’ balance sheets in order to comply with this update. It will be important for you to monitor the status of this update and begin planning now, so there are no major surprises on your financials that could cause issues with creditors, investors or other interested parties.
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This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax-related matter.