Equipment Leases

Equipment Leases

September 15, 2010

Equipment leases will have to be put on balance sheets under a proposal the two accounting standards boards released in mid-August.

The proposal is expected to force lessees to bring $640 billion in leased assets back on to their books. Comments are being collected until December 15. The proposal will apply to existing leases once it takes effect. No effective date has been set yet, but speculation is it could take effect as early as June next year.

US companies that use GAAP accounting classify leases currently as “capital leases” or “operating leases” for book purposes. Capital leases are a form of financing and the obligation to pay rent is treated like debt. Operating leases are off balance sheet. An example of an operating lease is renting a car from Hertz or Avis.

FASB and the IASB — the Financial Accounting Standards Board in the United States and the International Accounting Standards Board in London — made the proposal in a joint exposure draft. One goal is to bring reporting of leases in the United States in line with how they are treated in other countries. The boards also said that they felt they have an obligation to investors who have told the board the investors must add back lease obligations when evaluating public companies in order to get a true picture of how deeply the companies are indebted.

The new rules will make lessees who have been using operating leases look like they are carrying more debt. PricewaterhouseCoopers said it expects the proposal to add about 58% more debt to the average company’s balance sheet. This is a concern in the current economy with many companies already close to the edge in the amount of debt that lender covenants allow them to carry. At the same time, lessees may experience an increase in earnings if the rents are treated as equivalent to a debt rather than a running expense.

How lessors book the assets will depend on whether they are running a real rental business in substance where they keep getting the assets back. If yes, then a lessor would use a “derecognition” approach where it removes from its books the cost of the rights it has transferred to the lessee, but records the residual value as an asset. If not, the lessor will have to use a “performance” approach where it removes the asset entirely from its balance sheet, but has a liability to allow the lessee to use the asset. Lessors in both cases would record rental income over the lease term.

The lessee would have to record an obligation equal to the present value of the expected rental payments over the lease term. Both lessors and lessees would be required to use the longest lease term that is more likely than not to occur.

The proposal is expected to have a significant effect on the continued attractiveness of lease financing. However, interest among renewable energy developers in leasing in the United States is being driven currently by other factors than keeping obligations off balance sheets.

Keith Martin