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Changing standards for leases: What lessees need to know

Given impending changes to lease accounting standards, lessees have three basic options.

April 4, 2013
by Angela Wheeler Spencer, CPA, Ph.D.; Monika Turek, Esq.; and Thomas Zachary Webb, Ph.D.

Off-balance-sheet reporting is one of the most attractive features of operating leases. This treatment and associated bright-line criteria, however, are the source of much criticism. In response, recent FASB and International Accounting Standards Board decisions indicate these structures will likely be brought onto the books of lessees, consistent with the right-of-use (ROU) model.

The exact details of the new standard are not final, and an effective date for transition has yet to be set. Indeed, a re-exposure of the proposal could come as early as this month. Regardless, lessees should begin planning now for this change in accounting.

This article outlines the potential financial statement impact of the proposed change and provides a number of points to consider in preparing for the transition.

In contrast to capital lessees, operating lessees currently report rent expense only on the income statement and disclose future minimum payments in the notes to the financial statements. Based on board decisions to date, however, the ROU model will apply to most noncancelable leases extending beyond one year. As a result, affected lessees’ statements of financial position will now report an ROU asset and corresponding lease liability, both initially measured as the present value of future lease payments.

Additionally, because the lease liability contains current and noncurrent components, working capital and current ratios will decrease. Related expenses, however, will be recorded by applying one of two methods.

If the lessee consumes a more than insignificant portion of the leased asset’s life, the interest-and-amortization (I&A) approach applies. Under this approach, interest expense is accrued on the lease liability and the ROU asset is amortized over the life of the lease. Otherwise, the single-lease-expense (SLE) approach applies, with lease costs reported as a single line item on a straight-line basis and ROU asset amortization equal to lease costs less interest associated with the lease liability for a given period.

If the SLE approach applies, minimal (or no) effects can be expected on the income statement and statement of cash flow. However, if the I&A approach applies, interest expense will be based on a lease liability that declines over time. As a result, early in a lease’s life, total lease expense (interest and amortization) will likely exceed currently reported rent expense, decreasing net income. Since total expenses related to the lease remain unchanged over the course of the lease’s life, the overall impact on net income will reverse in later years. Assuming the deductible portion of the lease remains unchanged, deferred taxes will also result. Further, considering that rent expense is classified differently than interest and amortization, EBITDA will increase. Likewise, similar changes should also be expected on the statement of cash flow. Exhibit 1 provides a complete example of these proposed changes.

Since academic evidence and policies of credit rating agencies, such as Standard and Poor’s, suggest users of financial statements currently adjust for off-balance-sheet operating leases, in some respects these changes should be of little concern. However, debt and compensation contracts often include financial-statement-based measures. While lenders may be willing to renegotiate covenants that don’t already account for future changes in GAAP, employers and boards of directors will need to likewise carefully evaluate employee incentive compensation agreements and the net effect of capitalization of leases.

Should your company change course?

In light of these impending changes, it is likely lessees will respond with real economic changes. Lessors have expressed concern. For example, in its 2011 10-K, Alexandria Real Estate Equities said that such changes may materially impact the terms of leases and demand for leased properties, thereby adversely affecting lessor operations. Likewise, a 2011 Deloitte survey found that a significant portion of respondents expect capitalization of operating leases to impact existing debt covenants and make it more difficult to obtain financing. Given the impending changes, lessees have three basic options: (1) renegotiate existing leases to a shorter term; (2) maintain current lease arrangements; or (3) replace lease agreements with traditional financing. This article explores pros and cons of each.

Renegotiate

With lease terms of less than one year exempted from capitalization under the current proposal, renegotiation of lease agreements to a shorter term is one possible alternative. If debt covenants or other contract provisions are a concern, this may be a particularly attractive option. However, lessees must also consider that short lease terms place the lessor in a position of greater risk and also require increased internal coordination. Therefore, shorter arrangements will also likely carry higher costs.

Maintain

Even without off-balance-sheet treatment, leases are still an attractive option. Because leases often provide 100% financing, they allow companies to retain greater amounts of cash compared to traditional debt financing. Further, leases obligate the company for only a portion of the total cost of the asset, thereby enabling companies to preserve debt capital. As Bristow Group Inc. proclaimed in a May 2012 Form 8-K, “Operating lease strategy: lowering the cost and amount of capital needed to grow.”

Operating leases may also be more affordable because they offer real economic benefits to lessors, thereby lowering costs to the lessee. First, lessors in relatively higher tax brackets may need the greater deductions associated with property ownership. By entering into a lease agreement, a low-tax lessee can effectively “sell” the deductions associated with ownership to the lessor. Second, leases are afforded special treatment in the event of bankruptcy, making leasing a more secure investment for lessors.

Additionally, lessees are able to deduct reasonable costs associated with a lease. While the cost of acquiring a lease is deductible, it must be amortized over the life of the lease. Examples of deductible costs of acquiring a lease are: consideration paid; payment of past taxes or other obligations; and obligations to improve property or pay the lessor the difference at the end of the lease term if the improvement is not made.

A lessor’s property taxes and interest may also be deductible to the lessee (in addition to lease payments) if the lessor transfers the cost of those payments through the lease terms. Internal Revenue Code Sec. 162 requires that all business expenses be (1) ordinary and (2) necessary, while some courts add in a reasonableness standard for all business expenses. Typically, the courts will scrutinize reasonableness only with regard to related parties. As defined by Sec. 267, related-party transactions are exchanges among relatives or between an entity and its owners (partners, shareholders, estates, etc.). Otherwise, transactions between unrelated third parties are considered “at arm’s length” and are implicitly reasonable in nature.

Through 2013, a lessee may also be able to deduct 50% of the cost of “qualified leasehold improvements” in the first year the property is placed in service. Sec. 168(k) defines “qualified leasehold improvement property” as an “improvement to an interior portion of a [nonresidential] building” and made pursuant to the lease, by the lessor or lessee, to be occupied exclusively by the lessee and “placed in service more than 3 years after the date the building was first placed in service.”

Depreciation deductions are allowed for qualified improvements made by the lessee if, under the terms of the lease, the lessee makes improvements through its own funds (Temp. Regs. Sec. 1.263(a)-3T). Improvements made by the lessor, or made with money borrowed from the lessor, are deducted through the lessor’s annual depreciation deductions related to the leased property. The cost associated with qualified improvement property is recovered through straight-line depreciation over a 15-year recovery period.

In addition to direct monetary benefits, leases can provide an opportunity to fix costs associated with an asset. For instance, if a lease agreement includes repairs and maintenance, the per-period cost associated with an asset becomes fixed rather than variable. Further, for young companies and rapidly expanding ones, leases can work as an effective strategy for asset acquisition. In addition to allowing lessees relative flexibility related to occupancy, leases allow companies to gain immediate access to substantially greater amounts of capital than does traditional financing. For example, in its May 2012 prospectus, North Denes Aerodrome Ltd. discussed operating lease financing as an alternate mechanism to finance capital expenditures, if operations failed to generate sufficient cash to execute its presented growth strategy.

However, if operating leases are retained, planning for the proposed leasing standard will involve communicating across corporate divisions. In addition to modifying information systems so that the lessee can properly measure and report leasing contracts, these arrangements need to be examined at the corporate and subsidiary levels for tax purposes.

For multistate tax purposes, the lessee must assess how the newly calculated amounts flow into multistate tax apportionment models. For example, an entity having nexus in a state with a three-factor apportionment formula must determine how the proposed leasing standard will impact the property-factor calculation.

For book and tax purposes, the entity will also need to assess how the lease classification change may impact deferred tax reporting. The entity may need to make the necessary adjustments to the Schedule M-1, Reconciliation of Income (Loss) per Books With Income per Return, for tax purposes and make adjustments to deferred tax accounts based on classification of the lease.

Replace

An entity that acquires property through debt, rather than leasing, has many of the same tax advantages as a lessee. Owners may deduct interest and taxes related to the acquisition of property as well as annual depreciation. Capital recovery for an owner of property will happen through the modified accelerated cost recovery system (MACRS) method of depreciation, which allows the maximum amount of depreciation deductions as soon as possible (Temp. Regs. Sec. 1.167(a)-4T). In addition, owners may be eligible to deduct some or all of the cost of property placed in service in the current year (Regs. Sec. 1.179-1(i)). This means, that for some businesses with sufficient income, the cost of property can be completely deducted in the first year of service.

Owners are also allowed capital recovery through depreciation on improvements to property. Unlike lessees, owners may recover qualified improvements as separate assets over the MACRS life rather than a 15-year recovery period using the straight-line method. However, there are instances where the improvement must be capitalized by adding the improvement to the basis of the original property and depreciating it over the remaining useful life (Temp. Regs. Sec. 1.263(a)-3T).

Compared to lessees, owners retain the right to any future appreciation of asset value. However, owners must also consider the tax cost of gains upon disposition of real and personal property. Depreciable business property held for more than one year typically has ordinary income consequences associated with gains upon disposition. Personal property, like machinery and equipment, results in ordinary income related to the lesser of (1) the gain realized or (2) depreciation allowed. Gains resulting from price appreciation are considered capital gains. Real property, such as buildings, will result only in ordinary income for corporate entities but may result in higher capital gains rates for individuals.

Exhibit 1: First Year of Lease Agreement
Facts: Five-year noncancelable operating lease requiring rental payments of $5,000 at the end of each year. A 10% rate of interest is appropriate, and the company’s effective tax rate is 35%.

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Angela Wheeler Spencer, CPA, Ph.D., is an assistant professor of accounting at Oklahoma State University; Monika Turek, Esq., is a lecturer at Oklahoma State University; and Thomas Zachary Webb, Ph.D., is an assistant professor of accounting at Mississippi State University.