Looking Ahead: Operating Lease or Capital Lease?

By Richard Parent, Executive Vice President, National Real Estate Practice, Gumbiner & Savett Inc.

On Aug. 17, 2010, the Financial Accounting Standards Board published jointly with the International Accounting Standards Board a proposal for public comment that is expected to make significant changes to the financial reporting for lease contracts. The board is requesting feedback on the proposed standard by Dec. 15, 2010, which is anticipated to go into effect sometime in 2012.

The proposed changes for lessees will require all leases to be classified as capital leases, thereby eliminating the distinction between capital and operating leases.

Essentially, the reclassification will move the obligation to pay lease rentals and a right-to-use asset to tenant balance sheets. The amount of the obligation will be equal to the lease rental payments discounted at the lessee’s incremental borrowing rate and will be re-measured at each reporting date. This will drastically change company financials, since recoding these obligations may change the way investors analyze company balance sheets.

A lessee will recognize an asset representing the right to use the leased asset for the lease term and amortized over the shorter of the expected lease term or the estimated useful life. Under current standards, however, when leases are classified as operating, these assets and liabilities are not recognized; thus, they are recorded in the income statements as lease expense when paid. With the anticipated changes, all leases will fall under the capital lease designation and must be included on the balance sheet. Needless to say, for those in the real estate industry, this fundamental change will shift how real estate is transacted.

Lessors will recognize an asset representing the right to receive future lease payments and will apply a performance obligation approach or a derecognition approach to account for the assets and liabilities arising from a lease.

No one can predict how soon the new procedures will be implemented. Given the impact these changes will have on the real estate industry, careful—and early—analysis will allow company management to put the correct initiatives in place. Understanding the new reporting standards and developing a well-thought-out strategy on how real estate leasing should be handled moving forward will not only protect the company today, but position it for growth well into the future.