New FASB Capital verses Operating Leases:
Is your company ready for the new FASB accounting changes for Operating and Capital Leases?
As we move closer towards FASB's decision of the new accounting changes (3rd quarter 2010), it is becoming clear that tenants will be faced with major changes in the way they account for their leases, and in fact, major reductions to their bottom lines.
Current FASB 13 Statement:
The current FASB 13 statement establishes standards of financial accounting and reporting for leases by lessees and lessors. For lessees, a lease is a financing transaction called a capital lease if it meets any one of four specified criteria, if not, it is an operating lease. Operating leases are treated as a current operating expense for that period. (rent expense). However, capital leases are treated as the acquisition of assets and the incurrence of a financial obligation by the lessee. With a capital lease, the lessee is assuming some risk of ownership but enjoys some of its benefits. Thus capital leases are recorded on the tenant's balance sheet as a liability and an asset. The firm gets to claim depreciation for the location each year on the asset and can also deduct the interest expense component of the lease payments each year. Because of this, the tenant experiences a higher expense with a capital lease than with an operating lease Currently, as per FASB 13, one or more of the following Criteria needs to be met to be recorded as a capital lease:
- The lease automatically transfers ownership of the property to the lessee by the end of the lease.
- The lease contains a bargain purchase option.
- The lease term equals 75% or more of the estimated economic life of the property.
- The present value of the minimum lease payments at the beginning of the lease term equals or exceeds 90% of the fair market value of the property.
The New FASB Rulings on FASB 13:
The new proposed ruling is going to treat all leases as capital and must be reported on the tenant's balance sheet as both an asset and a liability. The calculation to value the lease would be the present value of the obligation or lease payments discounted by the incremental borrowing interest rate for the tenant. The borrowing rate is decided by the tenant's credit rating, the lease term (Total dollar amount). Accounting for options and other contingent rents would be measured as a liability as well as using the most reasonable information as the lease option expense. The traditional monthly rental expense for the tenant's location would now be recorded as a depreciation expense in addition to an interest expense entry. The interest would be more in the early years of the term and slowly reverse later in the term. Thus lessees with many leases will be faced with a higher expense in the early years of the term.
Lessees are advised to analyze their portfolio in order to understand the monetary impact resulting from the new FASB ruling. In addition, a process will be needed to determine if a lessee should buy or lease an asset and if they have adequate software to track and account for its leases. Lastly, this also applies to equipment leasing as well as real property.
Lease Administration Solutions, LLC can help! Whether for office, retail or industrial, we can help you determine your system needs. From calculating and populating the capital lease expense change, to recommending lease administration software we can help guide you through the process.