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When did leasing become owning?

For years, many companies in the United States and abroad have leased assets rather than purchase them. Issues of cash flow and bank financing compelled companies to choose leasing. Leasing often requires lower cash outlays and easier credit terms, and the payments may be tax deductible.

Companies do this knowing that during the life of the asset, the costs may be great, no equity is being generated from the ownership of the asset, and they may be losing out on other tax benefits such as depreciation. Additionally, most leases contain penalty provisions for early termination by the lessee.

Currently, under U.S. Generally Accepted Accounting Principles, companies may account for leases as either operating leases, where the lessee expenses the lease payments as they are paid, or as capital leases, which require the lessee to record on its balance sheet both the assets that were leased and liabilities for leased payments.

In the U.S., the criteria for determining whether a lease should be capitalized are: (1) the transfer of ownership at the end of the lease term, (2) a bargain purchase option that can be exercised by the lessee, (3) a lease term that is equal to or greater than 75 percent of the estimated useful life of the leased asset, or (4) the present value of the lease payments being equal to or greater than 90 percent of the fair market value of the leased asset

In August 2010, the Financial Accounting Standards Board and the International Accounting Standards Board issued a joint exposure draft on accounting for leases. The draft contends that "current practice omits relevant information about the rights and obligations that meet the definitions of assets and liabilities."

Instead of just expensing the lease payments as they're made, FASB and IASB advocate a "right to use model" whereby the lessee records the "right of use" as an asset and corresponding liability discounted using the leases' incremental borrowing rate for the present value of the lease payments, in addition to any indirect costs incurred by the lease. The right of use asset would be amortized over the estimated economic life of the underlying assets being leased, and the liability would be reduced by the payment amount net of interest expensed at the company's incremental borrowing rate. Lease payments would continue to be recorded as a financing activity, consistent with the current accounting treatment of capital lease payments.

Amortization and interest expense from the right of use asset should be presented separately in the income statement or the footnotes.

Implementation would require companies that are leasing assets to "assume the longest possible term that is more likely than not to occur," meaning companies couldn't create a series of constructive options to circumvent the proposed rules. Under current guidelines, many leases are structured as operating leases by using options to keep the term of the lease below the 75 percent of the economic life of the asset threshold.

In addition to the work necessary for many larger companies to implement this change, some opponents note other implications associated with adopting this accounting treatment. Capital-intensive companies that lease assets--such as automobile and chemical manufactures, oil companies and transportation companies--could exponentially increase the amount of assets or liabilities on the balance sheet. This could reduce working capital ratios for the current portion of the lease obligations.

A recent Goldman Sachs report noted that many of the United States' largest retailers would be among the most affected businesses, since they lease most of their retail space under long-term leases that are structured as operating leases under current guidance.

Also, many banks and lending institutions generate significant revenue from leasing assets to these companies. These lenders may find that companies have less incentive to procure their assets through leases, which could dry up another revenue stream for the financial industry, a sector recently hit by greater regulations, capital requirements and losses of other revenue streams.

The FASB and IASB have not set a firm date for implementation. However, both bodies agree that substantially all leases will be capitalized on the balance sheet in the not so distant future. Companies will need to consider the ramifications of this accounting rule change for the balance sheets.

Brian Ettehad, CPA, is an audit manager with Frost PLLC of Little Rock. His practice centers on public companies, food and agriculture, and government and nonprofit organizations.
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Author:Ettehad, Brian
Publication:Arkansas Business
Geographic Code:1U7AR
Date:Sep 19, 2011
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