Once upon a time everyone thought they could tell the difference between renting something and owning something. Being able to tell the difference was important to accountants because the things you owned were on your balance sheet as assets and the things you were renting were not. And, if you borrowed money to purchase the things you owned, that liability for the loan was also on your balance sheet.

In the late 1960’s and early 1970’s people began to get creative with something called leases – long-term rental agreements. Soon the leasing people were developing agreements that, although called a Lease, were actually a long-term sales agreement with financing. This prompted the accounting rule making body (the Accounting Principles Board) to promulgate rules for distinguishing a lease from a purchase and recording it accordingly. This became a task more complex than anyone imagined. At one time, more than 50% of the literature devoted to defining generally accepted accounting principles was devoted to lease accounting rules and regulations.

Now, 40 years later, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are at it again. Under the proposed changes, all leases would be treated as capital leases resulting in an asset and a liability appearing on the balance sheet reflecting the economic reality of the transaction.

Existing and new leases will be capitalized based upon the present value of the estimated net lease payments over the expected lease term, discounted at the lessee’s incremental borrowing rate. The capitalized value will include base rent, net of operating expenses, for the longest term of the lease that is more likely than not to occur, with consideration of renewal periods and termination rights, and the expected value of contingent rent and other payment amounts over the same period. As you can imagine, these calculations will be daunting and cumbersome as organizations must capture new date points and capitalize obligations based on internal evaluation of occupancy practices and the use of property. The terminology that will be used on the balance sheet to describe the capitalized value of the asset will be a “Right-to-Use” asset, amortized over the lease term in a manner that reflects the pattern of economic benefits (usually straight-line).

Since new assets and liabilities will begin appearing on the balance sheet the potential for these new figures impacting ratios that measure the effective use of capital and indebtedness is of a concern to many businesses – not-for-profit organizations included. With few exceptions, return on assets and return on investment will decrease, and debt-to-equity ratios will increase, in some cases, exponentially.

For service providers that lease multiple locations, the impact could be huge. Long-term debt will increase overnight when this proposal goes into effect. In addition, placing the full lease obligation on the balance sheet will produce a negative impact on the results of operations. In most cases, the “right of use expense” will be greater than the old lease expense in the early years as one depreciates the asset and records the interest implicit in the payment agreement.

The proposed Accounting Standard Update does not apply to short-term leases, defined as leases having maximum possible terms (including renewal options) of 12 months or less.

Originally, it was believed that these new rules and regulations would be issued by now and be effective on January 1, 2013. That is now thought to be impossible with a January 1, 2015 date looking like the target implementation date right now.

What can you do now?

• Take a look at your existing credit arrangements and the loan covenants that specify meeting certain ratios and begin to discuss with your lender(s) the need to modify those covenants when the new leasing principles go into effect. For new loans, be sure that you and your lender agree on the need to modify the loan covenants when the rules change.
• Related Party Leases - Are you one of those entities considered the primary beneficiary of a variable interest entity (your typical operating company owned by the same individual(s) as the members of the LLC that own the property leased by the company) that have chosen to take a GAAP departure rather than consolidate the LLC (the variable interest entity). Under the soon to be new rules explained above, the operating company would have to capitalize its lease of the operating facility with the LLC. It may be less onerous to rather consolidate the LLC, as the lease with the LLC is eliminated through the consolidation process, as opposed to going through the process of capitalizing the lease.

What do you think of the new leasing rules?

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As one of the largest CPA firms in Boston, KLR is unique because they service over 220 not-for-profit organizations with compliance and consulting services. We have extensive experience helping Nonprofit organizations regarding boards, and board responsibilities, charitable contributions, taxes and 990 filing requirements.