New Rules for Accounting for Your Capital Lease or Operating Lease
Whether you classify your lease as a capital lease or as an operating lease, new federal regulations regarding how that debt is recorded will be enacted soon.
Significant change is coming to the way companies account for their leases. The standard-setting board in the United States, the Financial Accounting Standards Board (FASB), has proposed rules that will treat all leases similar to “capital” leases, meaning that companies will be required to record debt on their books for all leases.
In the past, companies classified leases as either “operating” or “capital.” With an operating lease, the total lease rent obligation is not recorded on a company’s books and only appears as a footnote disclosure in a set of financial statements. Under capital leases, a company records the lease rent obligation as debt and a related lease asset.
Most companies have preferred to enter into an operating lease, since this classification avoids debt being recorded on the books. Further, many lease arrangements that normally would have been capital leases were specifically designed to bypass the criteria that trigger capital lease classification.
The lack of a lease liability being recorded on companies’ books through the avoidance of capital lease classification has been the source of frustration to investors and other interested parties. In order to derive what they view as a truer reflection of companies financial positions, investors and others routinely make adjustments to companies’ financial statements in order to reflect them as if all the leases were capital leases.
The lease rules are also cumbersome to accountants and auditors alike, who, in order to determine the correct accounting, have to wade through numerous interpretations and guidance issued since the current model of lease accounting was introduced in 1977.
Recognizing these shortcomings of the current lease rules and in an effort to align U.S. lease rules with those of the international community, the FASB embarked on a joint project with its international counterpart to create a lease accounting model that would reduce the complexity and eliminate the game-playing between operating and capital lease classification. The result of the joint project was a proposed set of lease rules that include the following:
- Elimination of operating lease vs. capital lease classification
- Recording all leases on a company’s books, with a lease liability and right-of-use asset
- Measurement of the lease liability as the present value of the lease payments, including renewal options where there is significant economic incentive to renew
- Measurement of the right-of-use asset at the amount of the lease liability
In feedback to the FASB, many have argued that certain provisions of these rules are overly complex and attempt to turn accounting into economic forecasting. These criticisms and the sheer volume of feedback received have caused the FASB to re-deliberate the proposed lease rules. However, while some of the particulars of the proposed rules may change, what is certain is that the basic tenants requiring all leases to be recorded on companies’ books will remain.
When the final rules go into effect, there will be no grandfathering of a company’s existing capital lease or operating lease. In other words, all existing leases will be required to be shown on companies’ books, and when presenting a companies’ books in a set of financial statements, prior periods in those financial statements will also need to be updated to reflect the lease obligations in those years. Certain industries, particularly real estate and other capital-intensive industries such as restaurants, retailers and transportation, will be especially affected by the sudden appearance of all their lease debt on the books.
One effect of the new rules, potentially unintended, is that EBITDA (Earnings Before Interest Taxes Depreciation and Amortization), a commonly used metric by management and investors to measure a company’s cash flow, will increase. The new rules are expected to replace a company’s rent expense with amortization expense from the right-of-use asset and interest expense from the lease liability, and consequently, EBITDA, as presently defined, would increase since both amortization and interest are excluded from the calculation. Financial professionals who frequently use EBITDA to evaluate a company’s financial performance should be aware of this artificial increase to EBITDA.
The increase of debt on the books will likely negatively impact a company’s ability to meet its bank debt covenants. These covenants can include a current ratio and leverage ratio, which measure a company’s assets and equity, respectively, relative to its liabilities, and a coverage ratio, which measures a company’s ability to make its current debt payments. The addition of lease debt on the books will be a drain to these ratios. As such, careful consideration should be given to these bank debt covenants before and after the new rules become effective.
Aside from the direct financial effects, the new rules are likely to induce changes to economic behavior as well. Leases with longer terms will become unattractive on account of the associated debt burden being put on the books. Likewise, renewal options are also likely to wane in popularity for the same reason.
The new lease rules will have a significant impact, both financially and economically. With a second draft of the new lease rules scheduled to be issued in the fourth quarter of 2012 and the final rules to follow, the time to prepare has come.