The proposed new rules on accounting changes for leases won’t go into effect until at least 2012, but the leases you sign now will be subject to those new rules.
As a result, businesses especially those with many leases should begin now to familiarize themselves with the proposed changes, says Peter Eames, assurance manager at Burr Pilger Mayer, Inc.
“This is going to create a significant amount of work for companies that have a lot of leases or that have complex lease terms, such as contingent or percentage rents,” says Eames.
The comment period on the new rules closed on Dec. 15; the final standards are expected to be released in the middle of 2011, and implementation should be no less than a year after that, he adds.
Smart Business spoke with Eames about how the standards are changing, and what businesses should be doing now to prepare.
What changes are being proposed to accounting standards for leases?
In short, the old classification system, with off balance sheet operating leases, is being done away with. The proposal is for all leases to be carried on the balance sheet. Under the old rules, if your leases met certain criteria, you could call a lease an operating lease; the rent would be recognized as expense every month and the lease would never have to be recorded on the balance sheet. Additionally, estimates of contingent rents will have to be booked up front, which can become quite complex.
Under the new proposal, leases will be treated more like debt, similar to what is presently done for capital leases. If you are leasing an asset, you will record a liability on your balance sheet for your obligation to make payments, and an asset representing the right to use the leased asset over the term. The liability will be discounted so you will have to recognize interest expense over the life of the lease, while also recording amortization expense for the decrease in the value of the right-of-use asset.
Currently, if you sign a 10-year office lease, the obligation probably is not showing up on your balance sheet. Common-sensewise, if an investor wants to know about a company’s obligations, presentation of its lease obligations on the balance sheets, instead of the footnotes, is more transparent.
How will the new rules change how companies do business?
For smaller companies, companies not in the retail space or that don’t have a lot of locations, the accounting burden shouldn’t be overwhelming. The proposed standard will apply to nearly all leases, from copiers to real estate, but a little bit of spreadsheet jockeying will probably be all that is necessary.
Retail companies, however, which may have hundreds of leases, are going to need more robust accounting policies and systems. They’re going to have different incentives in negotiating leases, potentially avoiding lengthy terms and contingent rents to avoid putting large liabilities on their balance sheets and to avoid the complex accounting for contingent rents. It may also lead to the renegotiation or amendment of a lot of debt agreements.
Will the new guidance apply only to new leases, or will it be retroactive to existing leases?
The proposed guidance includes a simplified retrospective application approach, which essentially says that you won’t have to start accounting for each lease at the beginning of that lease. So when you implement the new guidance, you will act as though you just entered into all of those leases and record an obligation for the remaining future payments on the leases as of that date. Almost nothing is grandfathered in, but you are going to be able to pick up those leases in the middle of the term and just account for the remaining term.
If the new rules won’t be implemented until 2012 or later, why should business leaders be concerned now?
If you have leases coming up for renegotiation, you may find that the landscape has changed; if you’re dealing with someone who’s doing a lot of leasing on the other side of the negotiation, you may be surprised at what they bring to the table.
Just having a basic working knowledge of this can really help you renegotiate leases and bank covenants, as well. And if you’re signing long-term leases, you’re going to be much happier if you get a structure now that’s going to be simpler to account for in the future. It may seem like implementation is a long time away, but for anyone signing 10-year leases, most of that lease is going to have to be accounted for under the new guidance.
Lease and debt accounting will be similar, with both the liability and interest expense decreasing over time. Since expense will be higher in early periods of leases, net income will initially be lower than under the old guidance, which might even cause covenant compliance issues for some companies. On the other hand, a company that has an EBIDTA covenant is going to have an easier time meeting its covenant.
If a company is involved in a lot of leases, it should begin to prepare now by looking at system changes that it might need to make to adapt to this. In addition, while companies won’t have to implement the new guidance for at least a year, when they do, they’re going to have to apply the guidance to prior periods. Soon we’re going to be entering the periods that are going to have to be shown under the new guidance when they are shown as prior comparative periods. Business owners should be thinking now about preparing for the new presentation requirements.
Peter Eames is an assurance manager at Burr Pilger Mayer, Inc. Reach him at (415) 671-7610 or firstname.lastname@example.org.