Publications

---

Corporate holders of leasehold interests in real estate (or equipment, for that matter) should be aware of a significant proposed change in accounting procedures required under SFAS 13 to be in compliance with generally accepted accounting principles.

In 2009, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued a joint discussion paper advocating changes to the accounting treatment of leases, namely that no lease of real estate or equipment assets should be treated as an off balance sheet asset. Essentially, the proposed changes to SFAS 13 eliminate the distinction between operating leases and capital leases and characterize all leases as “finance leases.” Under the proposed changes, a lease of real estate or equipment assets will be capitalized and put on the lessee’s balance sheet as an asset valued based on the present value of the lessee’s right to use the leased asset, with a corresponding liability based on the present value of the lessee’s rental obligation with respect to the leased asset, over the term of the lease.

Currently, a lease may be characterized as an operating lease under SFAS 13 unless the lease runs afoul of one or more of four criteria based on the length of the lease term, the amount of rent payable over lease term, inclusion of a bargain purchase option, or a transfer of ownership of the asset to the lessee by the end of the lease term, in which event the lease is treated as a capital lease. Those criteria will be discarded under the new rule in favor of a blanket determination that all such leases are finance leases.

Commentators generally expect that the changes will be implemented in a form that eliminates operating lease treatment, not only for leases entered into after the rule is changed but for existing leases as well. In other words, no leases will be grandfathered under existing rules. All leases will be characterized as finance leases.

Current estimates indicate that moving existing operating leases to the balance sheet will affect the characterization of more than $1 trillion of real estate assets and another $300 billion of equipment and other personal property assets.

The FASB and the IASB have closed the comment period on the joint discussion paper. An exposure draft containing the formal text of the proposed rule is expected to circulate in mid-2010, with the formal standard to be adopted in mid-2011 and having an effective date in 2013.

The impact of the proposed changes to SFAS 13 may include the following:

• Expenses under leases will no longer be straight-lined over the course of the lease, but will be front-loaded by what some commentators expect could be as much as 15 percent in early years
• Depreciation will be required, much as would be the case for owned assets
• Calculations of net income and EBITDA will be affected
• Putting leased assets on the company’s balance sheet will change its debt-to-equity ratio. A company may appear more highly leveraged than its balance sheet previously indicated
• A company's return-on-asset calculation will also be affected
• These changes may result in a breach of loan covenants, requiring renegotiations with lenders

What should be done in advance of any FASB rule changes? Your main objective should be to work with auditors to understand the significance of the changes to your company and to determine whether any change in strategy is appropriate, for existing leases and certainly for future facilities requirements.

For example, in some cases, a company may seek shorter lease terms (reducing the capitalized liability) or may consider purchasing rather than leasing at all. In other cases, it may be necessary to take the proposed accounting changes into consideration in negotiating or renegotiating a company's debt covenants to more accurately reflect the company’s financial condition after the new rules.