The proposed changes to lease accounting standards would classify all leases as capital leases and require them to be reported on company balance sheets. This would significantly increase reported assets and debt for most companies by including operating leases. It would also change key financial metrics and reduce comparability to prior periods. Companies should analyze the potential impact on their financial statements and metrics and prepare for the administrative changes needed to implement the new standards for all existing leases.

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members speak out
Are Operating Leases Dead?
George Boyadjis
P
otential changes in lease account- claim the adjustments are inconsistent and will no longer be straight lined. Rather,
ing are likely to have huge conse- frequently understate the lease obligations. occupancy costs — amounts formerly
quences for the balance sheets of treated as operating rent expense — will
most companies and nonprofits. Specifics of the New Proposal be higher in the earlier years (as much as
Operating leases will become capital leas- The proposed standards presume that all 15 percent) and lower in later years.
es, resulting in the shift of trillions of dollars leases give rise to assets (the “right to Metrics such as debt to equity, interest
onto balance sheets. With all leases for com- use” the leased assets) and liabilities coverage, EBITDA and return on assets
mercial real estate space being capitalized (future rental payments). The proposed will change, and comparability to prior
in this way, the assets and debt of many new principles for lessee accounting are: periods will be affected.
companies will increase dramatically. All leases, including leases at the cut- For many companies, EBITDA (a proxy
In addition, measurements of earn- over date, will be treated as capital leases. for cash flow) will increase due to a
ings before interest, taxes, depreciation Leases will be capitalized based on the reduction in recorded rent expense and
and amortization (EBITDA) will increase present value of the lease obligation, increases in recorded amortization
as rent expense disappears and is using the company’s incremental borrow- expenses and interest expenses under
replaced by higher leased asset amortiza- ing rate. the new rules.
tion and interest expenses. Capitalized lease values will include Companies with significant operating
With so much change in the offing, base rent, residual payments, obligated leases will face a heavy one-time adminis-
FEI members need to understand the renewals and contingent rents. trative burden since they will have to collect
proposed new accounting standards and Rent expense will cease to exist; and input substantial data and perform
plan now. Why is this so important? instead, interest expense and leasehold new calculations to determine the amounts
Because all leases that exist as of the offi- amortization expenses will “replace” rent to be capitalized. They will need to plan for
cial change will have to conform to the expense in the income statement. new processes and software solutions to
new standards and current operating Balance sheets will include a category facilitate the necessary changes.
lease treatment will not be grandfa- for leased assets separate from other
thered. In addition, a recent survey by fixed assets. What Should You Do Now?
Core Net Global indicated that 83 per- While operating leases are not yet
cent of companies were unfamiliar with What Will Be the Impact? “dead,” it’s fair to say that their progno-
the proposed changes. Based on comment letters, the proposed sis is not good. So companies should
changes seem inevitable, and repercus- begin today to understand the issues and
Why Proposed Changes Now? sions will be considerable. Virtually every implications of the proposed new rules.
The Financial Accounting Standards Board organization will be affected, since most The first step is to meet with staff
and the International Accounting Stan- businesses have leases for real estate internally or with business advisers who
dards Board recently issued a joint Discus- space, computers, office equipment, specialize in these matters. The initial
sion Paper detailing the changes to oper- vehicles, among other things. focus should be on updating your lease
ating leases, a component in the boards’ This change will likely affect numer- administration database so you can ana-
convergence program. The impetus for ous metrics — including debt covenants, lyze and understand the impact of the
the proposed changes dates back to the financial performance assessments and proposed changes, then review alterna-
accounting scandals that raised concerns management compensation, etc. — tives and strategic options.
about off-balance sheet accounting. meaning extra work will be needed to
Concerns about the current rules adapt. George Boyadjis, CPA, FHFMA, is a mem-
include: Undisclosed liabilities in the form Among other challenges: ber of the Twin Cities Chapter of FEI and
of lease obligations, lack of transparency Corporate balance sheets will inflate vice president at large and member of
and comparability and “form over sub- significantly. Many companies will appear FEI’s Office of the Chair. He is executive
stance” transaction structures. much more highly leveraged, potentially director of CresaPartners, a corporate
While balance sheets are adjusted by changing their characteristics as desirable real estate advisory firm, and the largest
bankers and analysts to approximate the investments. such firm in North America exclusively
debt implied by operating leases, critics Expenses related to leased properties representing corporate users of space.
www.financialexecutives.org december 2009 | financial executive 63