Looming Lease Accounting Rule Changes: Impact on Earnings, Debt Covenants, Compensation Arrangements, and Earnout Agreements

A proposed change to lease accounting rules appears to be gaining traction and could have a large impact on both the debt reported on a company’s balance sheet and its earnings before interest, tax, depreciation, and amortization (EBITDA). In general, the change will affect all companies that lease assets (e.g., real estate or equipment), regardless of the type or value of such assets. The change in lease accounting also will affect commercial, financial, and employment-related plans and agreements that use financial ratios or EBITDA measurements, including debt agreements, compensation agreements, and earnout agreements.

On March 19, 2009, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB, and together with the FASB, the boards) issued a joint discussion paper on accounting for leases by lessees. The boards’ joint project on lease accounting is part of the 2006 Memorandum of Understanding between the boards to work toward convergence of accounting standards. Among other changes, the proposal in the discussion paper would require all leases to be treated by lessees as capital leases (known as financing leases under international financial reporting standards). Accordingly, lessees would no longer be able to treat any of their leases as operating leases.

Current Lease Accounting Standards for Lessees Under U.S. GAAP

Existing lease accounting standards require lessees to classify their lease contracts as either capital leases or operating leases. Capital leases are defined as leases that transfer to the lessee substantially all of the risks and rewards incidental to ownership of the leased asset. All other leases are classified by lessees as operating leases. Since capital leases are viewed as similar in substance to a purchase of the underlying asset, the lessee recognizes an asset for the leased item and a corresponding liability for the obligation to make the lease payments. The lessee depreciates the leased item and apportions the lease payment between interest expense and a reduction of the lease liability. Alternatively, if the lease is accounted for as an operating lease, no asset or liability is recognized on the balance sheet. Rather, the lessee recognizes lease payments under an operating lease as an expense, normally on a straight-line basis over the lease term. In order to avoid recognizing the obligation to make payments under a lease, many lessees attempt to structure their lease transactions so that operating lease treatment will be permitted.

Criticisms of the Existing Lease Standards

Existing lease accounting standards have been the source of debate for many years. Many financial statement users believe that the distinction between capital leases and operating leases is an artificial one and that operating leases, like capital leases, give rise to assets and liabilities that should be recognized on a lessee’s balance sheet. In fact, many financial analysts ignore the distinction and attempt to capitalize a company’s operating leases when making projections or analyzing the company’s balance sheet. Other criticisms of current lease accounting rules include:

• The difficulty experienced by issuers and auditors in drawing the line between operating and capital leases in a principled way, given the mixture of subjective judgments and “bright-line” tests
• The opportunity to structure transactions to achieve a particular lease classification
• The lack of comparability when one company classifies its leases as operating leases and another company classifies similar leases as capital leases
• The lack of sufficient footnote disclosure relating to operating leases necessary to make adjustments to recognized amounts for leased assets and liabilities

Critics also point out that current lease accounting standards are conceptually flawed. In particular, upon entering into a lease, the lessee assumes a valuable right (the right to use the leased item). This right to use the leased item meets the boards’ definitions of an asset. Similarly, the lessee incurs a payment obligation that meets the boards’ definitions of a liability. However, if a lease is accounted for as an operating lease, these assets and liabilities are not recognized.

Recognizing the inadequacies of existing lease accounting standards, the U.S. Securities and Exchange Commission’s (SEC) report on off-balance sheet arrangements and special purpose entities issued pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 recommended that the FASB undertake a project to reconsider lease accounting standards. The discussion paper is the FASB’s first major step toward addressing the concerns of the SEC and other financial statement users.

Proposed Changes to Lease Accounting

The proposal presented in the discussion paper would essentially require lessees to treat all leases as capital leases, using a method the boards refer to as the “right to use method.” The boards believe that the right to use a leased asset is an asset and the obligation to make lease payments is a liability. Accordingly, these assets and liabilities must be included on a lessee’s balance sheet to faithfully represent the substance of the lease transaction.

The boards have proposed that the asset and liability should be recorded at the lessee’s cost. The cost of the leased asset would be determined by calculating the present value of the lease payments discounted using the lessee’s incremental borrowing rate. The boards decided against using the lease’s implicit rate because it is often difficult for the lessee to determine. The discussion paper also presents proposals for several other matters relating to lease accounting, including subsequent measurements and leases with uncertain terms or options.

Implications

If the proposal is adopted, the requirement that lessees treat all leases as capital leases will affect all companies that lease assets. Given the length of many leases and the boards’ stated goal of increasing comparability between companies, many commentators believe it is likely that leases existing at the time lease accounting standards are changed will not be “grandfathered in.” As a result, management should examine the impact of the potential change in lease accounting on both existing and future lease agreements. Three key considerations for management include the potential impact of the proposed accounting standard on:

• The lessee’s balance sheet. Under the proposal, lessees would be required to recognize assets and liabilities for all leased assets. Previously, such assets and liabilities were not recognized if the lease was accounted for as an operating lease.
• The lessee’s income statement. Although the total expense over the life of the lease will equal the total amount of the lease payments, regardless of whether the lease is accounted for as an operating lease or a capital lease, the timing of the expenses is different under the two methods. Unlike operating leases where lease expenses remain constant through the term of the lease (i.e., they are accounted for using the straight-line method), lease expenses under capital leases are higher in earlier years of the lease than in later years. Because the lease liability is amortized using the effective-interest method, the interest expense will be greater in the earlier years of the lease than the later years. In addition, the lessee will record depreciation expense in connection with assets recognized under capital leases.
• The lessee’s EBITDA. EBITDA of the lessee would likely increase as a result of the proposed lease accounting change since rent expense will be replaced with interest and depreciation expense, both of which are not included in EBITDA.

These changes affecting a lessee’s financial statements and other financial measurements also would likely impact a large number of corporate agreements, including:

• Debt agreements. The requirement to capitalize leased assets and the related obligations that were previously expensed periodically would increase both the assets and liabilities recorded on a lessee’s balance sheet. Although the increase is on a one-to-one basis, the inclusion of such assets and liabilities may affect the calculation of financial ratios included in many financial covenants commonly included in debt agreements such as debt-to-total assets and cash-coverage ratios. The impact on EBITDA and the income statement also would likely affect the calculation of financial ratios included in such financial covenants.
• Compensation, earnout, and similar agreements. As discussed above, the proposed change in lease accounting is likely to increase the EBITDA of companies that lease assets. This increase in EBITDA could increase bonuses, commission compensation, or earnout payments that are linked to EBITDA even though the company’s cash position has not changed and the company has not received any additional value for the increase in EBITDA.

Example Lease

Assume that ABC Corporation leases a piece of manufacturing machinery from XYZ Corporation. Other information related to the lease is as follows:

• The lease term is 10 years
• The useful life of the machine is 15 years
• ABC is required to make annual lease payments of $10,000
• The fair value of the leased equipment is $80,000
• ABC’s incremental borrowing rate is 10.56 percent

Under current lease accounting standards, ABC would treat the lease of the machine as an operating lease.¹ Therefore, ABC would not recognize an asset or liability in connection with the lease. Rather, ABC would simply expense the $10,000 lease payment each year as a rental expense. However, if the boards’ proposal is adopted, ABC would be required to treat the lease (and all other leases, likely including existing leases) as a capital lease. The following discussion demonstrates the hypothetical impact of treating the lease as a capital lease instead of an operating lease on selected financial ratios:

Debt-to-total-assets. Prior to considering the effects of the lease, ABC has a debt-to-total-assets ratio of 0.60 ($500,000 in total assets and $300,000 in total liabilities). If the lease is treated as an operating lease, no asset or liability is recognized, and there is no change to ABC’s debt-to-total-assets ratio. However, upon capitalizing the present value of the required lease payments ($60,000), ABC’s debt-to-total assets ratio would increase to 0.64 ($360,000/$560,000).

EBITDA. Prior to considering the effects of the lease, ABC’s EBITDA is $100,000. If the lease is classified as an operating lease, ABC would recognize rental expense of $10,000 per year. Accordingly, EBITDA in the first year of the lease would be $90,000. However, if the lease is treated as a capital lease, ABC would record depreciation expense of $6,000² and interest expense of $6,336³ in the first year of the lease. Since both depreciation and interest expense are not included in EBITDA, ABC’s EBITDA would increase from $90,000 to $100,000 if the lease is treated as a capital lease instead of an operating lease.

Net income. Although depreciation and interest expense are not included in the calculation of EBITDA, both items will reduce ABC’s net income. Accordingly, if ABC is required to capitalize the lease, its net income in the first year of the lease will be $2,336 lower than it would have been if the lease was treated as an operating lease.⁴ However, as previously discussed, the interest expense will decrease over the life of the lease, and ABC’s total net income over the life of the lease will be the same whether or not the lease is treated as an operating lease or a capital lease.

Cash debt coverage ratio. If ABC is required to capitalize the lease, ABC’s total liabilities will increase by $60,000 at the inception of the lease. Accordingly, ABC’s cash debt coverage ratio (cash provided by operating activities divided by average total liabilities) will be lower if ABC is required to capitalize the machine lease.

Times interest earned ratio. If ABC is required to capitalize the lease, its total interest expense will increase. Accordingly, ABC’s times interest earned ratio (income before interest and taxes divided by interest expense) will decrease if ABC is required to capitalize the lease.

Many of ABC’s other financial ratios will be affected by the classification of the machine lease as a capital lease, including ABC’s earnings per share and rate of return on assets.

What Lessees Should Be Doing Now

Due to the broad impact of the proposed change in lease accounting, companies that lease assets should analyze the effect of the change on corporate agreements, including determining whether such agreements allow for (or should be amended to allow for) the adjustment of any performance measures or financial ratios included in the agreements in order to account for changes caused solely by the potential lease accounting rule change.

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If you have any questions about this alert or would like to discuss the topic further, please contact your Foley attorney or the following individual:

Timothy H. Shea
Milwaukee, Wisconsin
414.319.7054
[email protected]