Leasing or buying? What’s better for your balance sheet?

Have you ever wondered why airlines don’t report airplanes on their balance sheets? This question has challenged accounting standard setters for years. Under current rules, each lease is categorized as either an operating lease or a capital lease. In an operating lease, the leased asset is not recorded on the lessee’s balance sheet. Most airplanes are leased as operating leases and only show up on the balance sheet of the lessor. All that could change when the FASB’s proposed rules on leases become finalized. Although there are differences in their proposals, both the FASB and the IASB jointly released proposed new rules. Comments on the FASB’s “Proposed Accounting Standards Update (ASU) on Leases” and the IASB’s “Exposure Draft on Leases” are both due December 15, 2010. The FASB’s proposal introduces a right-to-use model that would require lessees to record an asset. This raises the question of measurement. At what amount should a company put this “right-to-use” asset on its books? The FASB proposes the following measurement approach: Assets and liabilities recognized by lessees and lessors would be measured on a basis that: (a) Assumes the longest possible lease term that is more likely than not to occur, taking into account the effect of any options to extend or terminate the lease. (b) Uses an expected outcome technique to reflect the lease payments, including contingent rentals and expected payments under term option penalties and residual value guarantees, specified by the lease. (c) Is updated when changes in facts or circumstances indicate that there would be a significant change in those assets or liabilities since the previous reporting period. LEASE TERM In developing the longest possible lease term more likely than not to occur, a probability weighted approach is appropriate. Let’s say a company has a lease with a non-cancellable 10-year term and two options to renew for an additional five years. Assume that the company determines the probability for each term as follows: (a) 40 percent probability of 10-year term (b) 30 percent probability of 15-year term (c) 30 percent probability of 20-year term We know: 1)  The term will be at least 10 years 2)  There is a 60% chance the term will be greater than or equal to 15 years 3)  There is a 30% chance the term will be 20 years The longest possible term more likely than not to occur is 15 years at 60%. Therefore, the lease term is 15 years. CONTINGENT RENTALS Contingent rentals are to be included in lease payments. Once again, a probability weighted approach works best. Let’s assume the following: Scenario 1: the present value of contingent rent, discounted at the incremental borrowing rate, is $432,116. The probability of occurrence is 40%. Probability adjusted rent is $172,846. Scenario 2: the present value of contingent rent, discounted at the incremental borrowing rate, is $896,442. The probability of occurrence is 10%. Probability adjusted rent is $89,644. Scenario 3: the present value of contingent rent, discounted at the incremental borrowing rate, is $504,108. The probability of occurrence is 50%. Probability adjusted rent is $216,058. Contingent rent in this example would be $478,549. CONCLUSION The proposed new lease rules will impact not only the balance sheet, but many other areas, including financial statement disclosures, financial ratios such as EBITDA and book-tax differences. Lessees will experience a front loading of expenses. As such, many lessees may prefer to buy certain assets instead of leasing them. There has been little protest among lessees to employ a right-to-use model, so the rules as proposed are likely to pass. No date has been set for final rules. Companies should undertake impact assessments now and develop projections related to lease options and contingencies. Pluris can help you evaluate your inventory of leases to determine how they might be affected under the proposed rules. Now is the time to perform an impact assessment, as the rules are likely to pass in their current form or close to it, and comparative financials will need to reflect an appropriate amount of history.