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A New Accounting Standard: How FAS 13 Could Impact Your Bottom Line

Does your business lease real or personal property? Or perhaps you are in the business of leasing property to others? A Joint Exposure Draft (Draft) proposes a new accounting standard that may impact your business. The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) created the Draft to standardize the way lease liabilities are accounted for on balance sheets.

Under current rules, leases are classified as either ‘operating’ or ‘capital.’ Capital leases are characterized by the transfer of ‘sufficient risks and rewards of ownership' as determined by four rules. Satisfying any of these rules results in a lease being classified as capital. Otherwise a lease is classified as operating. Generally, making the determination that a lease is capital requires the recording of an asset and corresponding liability, while the determination that a lease is operating requires no such balance sheet entry. There are a variety of potential impacts that the Draft carries with it for business owners in a variety of industries.

From lease liability to loan default. Under the current rules, a business that just entered into a 10-year lease with four 5 year options for office space has a contractual obligation to pay the remaining amount of the 10-year lease, but does not record that obligation as a liability on its balance sheet. Under the proposed standard, that same business will have to account for the entire lease obligation on its balance sheet. The presence of these new liabilities could drastically change the business’s balance sheet – adding many more liabilities (and corresponding assets). While this may not at first blush seem significant, it could be because most commercial debt instruments contain covenants, including, often a debt to income covenant. Those covenants are designed to measure the health of a business and have been created under the current standard and normal methods of business. In the example above, without changing any of the business’s operations or other financial results, its balance sheet debt will have increased which may put it at risk of a default of its loan covenants.

It is impossible to predict what a creditor might do when confronted with this new, unexpected covenant default. However, in most instances, the business will not be able to cure the default and the creditor may have options that are a surprise to the business.

Determining the liability amount. Additionally, the Draft requires a relatively complicated analysis to determine the amount of liability to be recorded. It is not simply a matter of computing the remaining payments due under the current term of the lease. Other factors, such as the likelihood that the business may renew must be taken into consideration and revisited annually. These procedures will add cost, complexity and uncertainty to the accounting function of most businesses.

Leasing versus buying. The Draft may also impact the lease v. buy decision for many business owners, which could have an effect on the industries (real estate, lease financing) that are in the business of providing capital for leasing transactions. The sale-leaseback industry provides not only the space and equipment for lease, but also provides the capital for the acquisition of assets. A fundamental shift from leasing to owning may impact development, lease rates, credit availability, occupancy rates and more.

How to prepare for the change. For business owners, the first step will be to estimate the impact of accounting for lease liability on the balance sheet. That information will be necessary to review loan and corporate documents to assess potential consequences. Moving forward, business owners may also want to reweigh the benefits of leasing versus owning various assets.

It is important to remember that the proposed standard will affect almost all outstanding leases – in particular those that are presently classified as operating leases. As the proposal currently stands, there will be no grandfathering of existing leases. If you have questions about how the proposed accounting standard will impact your business, please contact Matt Troyer at 317-968-5419.

  • Partner

    Matt Troyer counsels clients in numerous areas of corporate and real estate law. As corporate counsel, Mr. Troyer routinely advises owners of, and executives within, privately held businesses on a wide range of matters and ...

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