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Lease Accounting, Financial and Other Covenants

By Gian-Michele a Marca and Barry A. Graynor

In August 2010, the FASB and IASB issued a joint exposure draft ' Leases. The exposure draft creates a new accounting model for both lessees and lessors, and eliminates the concept of operating leases. All outstanding leases will be subject to the new lease accounting rules ' there will be no grandfathering of existing leases. The boards are expected to issue a final standard in June 2011, but they have not yet decided on an effective date for the new rules. This article summarizes the new accounting model for lessees and addresses the impact the new model may have on financial and other covenants typically found in financing agreements, where the lessee is the borrower. (The new accounting model for lessors is beyond the scope of this article.)

Summary of the New Accounting Model for Lessees

  • Lessees will recognize a right-of-use asset for the lease term and a liability for their obligation to make lease payments. “Off-balance-sheet” leases will no longer exist.
  • Except for short-term leases (leases with a term of 12 months or less), the present value of the lease payments will be used in the initial measurement of the obligation to make lease payments, discounted by using the lessee's incremental borrowing rate or the rate the lessor charges the lessee, if it can be readily determined. The right-of-use asset will initially be measured at the same amount plus any recoverable initial direct costs, such as commissions and legal fees.
  • If the lease includes renewal options or early termination options, the lessee will need to estimate the probability of occurrence for each possible term in determining the lease term.
  • Under an expected outcome approach, the lessee will recognize contingent rentals and residual value guarantees as part of the lease liability.
  • Under the new rules, a purchase option will be accounted for only when it is exercised. The exercise price will not be considered a lease payment but part of the cost of acquiring the underlying asset. However, purchase options do factor into the analysis of whether the lease represents a purchase or sale of the underlying asset. If the lease contains a bargain purchase option, it generally would be treated as a purchase and sale under existing GAAP and therefore it would be excluded from the new accounting rules.
  • For leases previously classified as operating leases, rent expense will be replaced with amortization expense and interest expense. Amortization of the right-of-use asset will generally be on a straight-line basis. Interest expense will be front-end loaded, like interest on an amortizing mortgage. Therefore, net income could be lower in the first years of the lease under the new accounting rules than it would have been under current operating lease accounting. However, EBITDA would be higher because rental expense is not recorded.
  • For leases previously classified as capital leases, the existing capitalized assets and lease obligations, which are based on the greater of the present value of minimum lease payments and fair value, will be replaced with the right-to-use measurement and the present value determinations described above.
  • The new rules will require the lessee to periodically reassess the carrying amount of the obligation each reporting period “if facts or circumstances indicate that there would be a significant change in the liability since the previous reporting period.”
  • The new rules will result in additional temporary differences for income tax accounting purposes. State and local taxes may also be affected.

Example

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