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Preparing for the Impact of FASB's Accounting Lease Changes

The Financial Accounting Standards Board (FASB) has proposed changes to the accounting for lease arrangements that may have a significant impact on many public and private firms. As the new year approaches, companies should get a head start on reviewing and preparing for these changes, as the new standard will require compliance for all leases upon adoption, with no grandfathering or transition period.

The proposed changes are expected to be finalized in 2012 and would eliminate the distinction between operating and capital leases, so that an asset and a liability will be reported in a company's financial statements for each lease arrangement. The SEC estimates that greater than $1 trillion of real estate alone will transfer onto the balance sheets of U.S. corporations as a result of the new standard.

The accounting and reporting for all leases will be affected (including real estate, equipment, vehicular, and technology leases) and will require the disciplined re-crafting of a firm's financial statements and reporting processes. Many organizations, especially those that are highly leveraged, will need to address the impact of the proposed standard on their real and perceived financial health due predominantly to the increase in liabilities.

The Back Story

The suggested changes are a result of FASB's desire to bring a higher level of transparency and comparability to financial statements. Additionally, it addresses broader criticisms of the current standard, where liabilities relating to operating leases are underreported, and the categorization of operating and finance leases is inconsistent and highly susceptible to structuring a transaction to achieve a desired accounting treatment.

By recognizing all lease arrangements on the balance sheet (asset and liability), rent expense will be eliminated, thereby increasing EBITDA. However, interest expense related to the lease liability and amortization expense related to the lease asset will be recognized in the income statement, impacting net income.

As proposed, existing leases will not be grandfathered, so all companies will need to be compliant with the new standard when it is adopted. Between now and then, companies will need to focus on three main activities:

• The basic reporting requirements of the proposed standard will require a lease-by-lease assessment, including the extraction of relevant information; determination of most likely lease term; projection of all lease costs, including contingent rent as applicable; and assignment of incremental borrowing rates, so that the Present Value of the lease liabilities can be calculated for every lease.
• Lease administration systems and financial reporting systems will need to be configured or updated to monitor, track, and calculate the required assets and liabilities, and roll-up these calculations into the required financial statement format, including look-back comparisons.
• Interim financial reporting processes may need to be developed and implemented until SOX compliant processes can be fully integrated into a company's operations.

What's the Impact on Your Business?

It is clear from FASB's Exposure Draft that the transition from the current lease accounting standard to the proposed standard will require additional inputs from across the organization, additional resources to manage / track lease data, and upgrades to processes and lease administration and financial reporting systems. However, the impact of the proposed accounting standard on a company's operations may be greater than merely accounting systems, processes and reporting, depending on the financial profile of each firm.

For healthy companies with low debt levels and moderate leasing activity, the impact of the lease accounting change should remain solely in the realm of financial accounting and lease administration, and the three activities noted above will need to be completed in order to meet the reporting standards.

However, firms with high debt leverage, significant number of leases, long-term leases, and / or high lease expenses will need to assess the impact of the proposed lease accounting standard on the real and perceived health of the organization, and determine if other operational measures may be warranted.

For instance, companies with significant leases will appear to be more highly leveraged, and their financial statement metrics will be impacted. While EBITDA will likely increase as rent expense is removed from the income statement, financial ratios also will be affected. Several case studies have shown that ratios conventional to credit instruments - such as Debt-to-Equity, Debt Service Coverage, and Interest Coverage - may be negatively affected by the addition of both assets and liabilities to the balance sheet at even low levels of capitalization. Such ratio changes may trigger technical defaults on credit obligations, requiring discussions with lenders, potential penalties and the need for lease or credit restructurings.

Similarly, companies with long-term leases of real estate or equipment - or plans to enter into such leases - will not receive the reporting benefits previously enjoyed under operating leases (off-balance sheet financing). These firms may need to revisit their lease vs. buy analyses, which have been biased toward leasing, and consider exercising existing purchase options, restructuring existing long-term leases into short-term leases, and revising their overall procurement strategies.

How Can You Prepare for the Changes?

While each company's situation is unique with regards to its financial profile, levels of debt and equity, credit covenants, and leasing exposures, there are preparatory actions that all firms should consider in the near-term, whether the impact on the business is solely accounting and reporting-related or if the accounting change leads to further operational issues.

• Identify key advisers. Assessing the operational impact may require a host of experts - both internal and external to the firm. Advisers may include experts in Accounting; Real Estate (lease analysis and lease administration); Debtor Advisory (debt instruments; analysis, negotiations); and Finance (ratio analysis, reporting impact) among others. Also, as the standard's effective date nears, the reputable and experienced external resources may become resource constrained due to other clients with similar needs. Better to get ahead of the herd.
• Conduct a diagnostic test. Companies should consider conducting a diagnostic test to assess the impact the accounting change may have on their financial statements. This would include gathering all lease information, assessing lease terms, and determining the impact of the new accounting standards on lease administration, financial reporting and other operational issues.
• Implement necessary systems changes. The standard will be effective very soon in "systems-time." Outline general user requirements, identify internal resources / champions, and select external consultants as needed. Any tweaks to the standard prior to its adoption can be accommodated before the systems and processes go live.
• Evaluate your leases vs. purchase options. Many companies may already recognize that their current procurement strategy needs to shift from leasing toward increased ownership. Before other firms realize the same and enter the market, the current economic environment is ripe for first movers as demand and pricing for real estate and other assets has been low by comparison.
• Talk to your creditors. Address the impact of the changes with your creditors through a fact-based analysis over time, determining the correct ratios that make sense for both parties, separating financial reporting issues from true financial health issues.

While the lease accounting changes are not expected to be effective until 2013 at the earliest, corporations are advised not to be caught on their heels, as the diagnostics assessments, system requirements, and implementations will require significant time and effort. Resources may become constrained as the effective date draws closer.

Companies should work with their advisers to assess the impact of the proposed changes on both the accounting and reporting and its operations. It will be important to prepare for the necessary lease administration and financial reporting process and systems changes; review existing lease terms and consider restructuring leases, if applicable; opportunistically exercise purchase options before new rules are effective. By performing the analysis and diagnostic early, companies will be able to start conversations with creditors to discuss how the impacts to ratio changes and possible covenant defaults should be addressed.