Impact of Lease Accounting Changes

Proposed changes to lease accounting rules could have a ripple effect.

At press time, the Financial Accounting Standards Board (FASB) is in the process of deliberating significant changes to lease accounting rules. If approved, this new lease accounting guidance would require U.S. companies, by some estimates, to record as much as $2 trillion in additional debt on their balance sheets. The proposed model could be effective as early as 2014 and would have significant implications for most businesses, including construction contractors.

If approved, the new guidance will introduce a right-to-use model. This model will require companies to record in their balance sheets estimated liabilities associated with lease payments and intangible assets representing the right to use specified assets. Lease contracts could no longer be structured as operating leases under the proposed standard, which would eliminate any opportunity for real estate and equipment off-balance-sheet financing. All leases would be treated similar to how capital leases are treated under current accounting rules.

The proposed standard does not allow existing leases to be grandfathered in. The proposed standard also does not provide an exception for equipment leases, such as copy machines, telephone systems or mailing equipment, incidental to a company’s core business. The administrative burden associated with the proposal may be significant for smaller businesses that lack large accounting staffs and for larger, sufficiently staffed businesses that have thousands of lease arrangements.

Companies would be required to estimate the ultimate lease term and payments to be made under all leases. These payments will then be discounted at a company’s incremental borrowing rate to arrive at the estimated lease obligation. Any direct cost associated with negotiating a lease will be added to the recorded amount of the right-to-use asset.

When determining lease terms and payments, companies will be required to assume the longest terms that are “more likely than not” to occur. Therefore, management will need to look beyond written contractual commitments, and make judgments for potential lease renewals and extensions based upon past actions and factors that reflect the company’s business needs. Leases maintained with related parties (whether written or verbal) and those maintained on a month-to-month basis, with related parties or others, will require special scrutiny.
When implemented, the proposed standard will increase a company’s total assets and liabilities without changing its net worth. However, these additions to the balance sheet may negatively impact certain financial performance measures, including tangible net worth and metrics related to a company’s total liabilities.

Although the total assets added may equal the total liabilities that must be added, remember that the right-to-use asset is considered an intangible asset under current accounting principles and, therefore, is excludable under proper tangible net worth calculations. The required lease obligation will be treated similar to a company’s other liabilities.

The proposed standard will not significantly impact a company’s reported net income over the lease agreement term. Lease payments under operating leases, which are currently deducted from net income, will be replaced by amortizing the right-to-use asset and the portion of the lease obligation that is treated as an interest expense. Given the declining nature of interest expense, however, the proposed guidance will negatively impact net income in the early years of a lease, when interest expense is the highest, and it will positively impact net income in later years of a lease, when interest expense is the lowest.

Interestingly, the proposed standard will improve reported measures of Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) and operating cash flows. The improved EBITDA measures will result from the extra amortization and interest expense in EBITDA calculations when operating lease payments were treated as deductions. Since the proposed standard would treat all leases as debt, a company’s operating cash flow will no longer include a reduction for rental payments. Instead, these amounts will be reflected as a financing activity.

Although the lease accounting guidance has not yet been adopted, construction contractors need to be prepared to address the impact to financial statements.

FASB Updates

On February 22, 2011, the FASB released minutes of its February 17, 2011 deliberations focused on its lease accounting exposure draft. The minutes describe certain tentative decisions intended to reduce the complexity of the original exposure draft.

The minutes reflect the board’s consideration of feedback that has been given related to the lease terms, the inclusion of contingent lease payments in a company’s lease liability and the distinction between leases and service contracts. The minutes also reflect the board’s consideration for making a distinction between leases that are primarily financing in nature and those that are not.

On March 15, 2011, the board tentatively agreed to allow companies to elect to exclude leases of 12 months or less from the asset and liability approach.

The final decisions on the lease accounting changes have not been reached—a final standard is expected to be to be issued in the second quarter of 2011.

Questions to Consider

Can a company avoid implementing changes from the proposed guidance for small equipment leases (since they are insignificant)?
Yes. As is the case with all standards, a company would not be required to apply the proposed guidance to immaterial items. However, exercise caution when applying this concept.

Construction contractors often arrange short-term leases that include a piece of equipment and an operator to use that same equipment. Will the proposed guidance also apply to these lease arrangements?

Yes. For leases that contain elements of both a service and a lease, the proposed guidance will require both components to be segregated and accounted for separately. The lease component will be accounted for under the new guidance, and the service component will be accounted for under other an applicable professional guidance. If the company is unable to segregate the components, the entire arrangement must be accounted for under the proposed lease guidance.

How should a construction business owner prepare for the possibility of the new guidance?

1. Meet with accountants, sureties, banks and other professional partners, and begin discussions about the standard’s possible impact.
2. Review buy-sell and other agreements to determine the impact the standard could have on formulas used in pricing company stock.
3. Advise all equipment providers and related operators of the possible need to have the pricing of those arrangements segregated between leases and services.
4. Evaluate existing and potential lease relationships with related parties and others for matters that might unintentionally expand lease terms under the “more likely than not” criteria.

Construction Business Owner, May 2011