Trent Parten

Tom Watson

In the paper, the FASB and IASB discuss a proposed change in lease accounting that effectively eliminates the “operating lease” treatment that applies to many of the leases used by health care providers. As drafted, the paper would require a lessee to recognize an asset (representing its right to use the leased item) and a liability for its obligation to pay rental under the agreement. For many leases, the ability to expense lease payments as incurred (with no asset or liability recognized) would cease. This approach aims for leases to be accounted for consistently across sectors and industries. The proposals are intended to improve the transparency, credibility and usefulness of lease accounting.

Accounting for Leasehold Obligations

Current U.S. GAAP guidance classifies leases in two categories—capital leases and operating leases. Such classification is determined by four key tests:

• Does title of the asset transfer at the end of the lease?
• Does the lease contain a bargain purchase option?
• Is the term of the lease at least 75 percent of the economic useful life of the asset?
• Is the present value of the future minimum lease payments at least 90 percent of the fair market value of the asset?

If the answer is “yes” to any of these questions, then the lease is required to be capitalized and recorded on the balance sheet. The asset is recorded at cost and the lessee’s obligation to pay is measured by discounting the future minimum lease payments

If the answer to all four questions is “no,” then the lease is classified as an operating lease and lease payments are expensed in the statement of operations.

Proposed Approach

If adopted, the proposed guidance would essentially mean all leases would be capitalized. As with current guidance, the boards have maintained the lessee’s right-of-use asset would initially be measured at cost. The boards have proposed that measuring the lessee’s obligation to pay rentals should be discounted using the lessee’s incremental borrowing rate.

The boards also discussed whether to require the lessee to revise its obligation to pay rentals to reflect changes in the incremental borrowing rate. The FASB tentatively decided not to require reassessment of the lessee’s incremental borrowing rate.

Under current U.S. GAAP, capital leases are recorded based on the fixed noncancelable term of the lease. The accounting treatment for leases with optional extension periods would change under the proposed guidance. The boards decided the lessee would consider the most likely outcome of an extension option based on contractual, non-contractual and business factors. For example, a 10-year lease with a five-year option would be recorded either as a 10-year or 15-year lease depending on the lessee’s particular business factors. Lessees would reassess the terms of each lease at each reporting date on the basis of any new facts or circumstances. Changes in the obligation to pay rentals arising from reassessment of the lease term would be recognized as an adjustment to the carrying amount of the asset.

The following example demonstrates the difference between an operating lease under current guidance versus a lease under the proposed guidance:

This proposed treatment will require more monitoring and record keeping and will generally result in higher expenses during the initial years of the lease term. Providers should start summarizing existing operating lease agreements and assess the impact of the proposed change on your financial statements once the exposure draft of the proposed standard is released. This will help limit the effort needed to implement the proposal when finalized.

For many health care providers with tax-exempt revenue bonds and other debt obligations, the proposal will affect many ratios used in debt covenants. Common ratios such as debt-to-capitalization, debt service coverage and day’s cash on hand may be affected. The proposal may also affect providers with covenants that limit additional borrowing in any given year, as many of these covenants include capital leases in the debt definition. Providers should consider this potential accounting change when issuing new debt or negotiating new leases. Also, once the exposure draft is released, providers should discuss current debt agreements with bond counsel, underwriters and lenders to ascertain how current covenants could be renegotiated once this change is implemented.

At its current pace, the FASB could release an exposure draft in 2010, and a formalized standard could be in place before 2012. If the final standard corresponds with the preliminary views document, it would affect all leases in existence at the effective date. Lessees would recognize an obligation to pay rentals and the right-to-use asset for all outstanding leases at the effective date, using the current incremental borrowing rate to discount lease payments.

Updates to this proposed guidance can be monitored on the FASB’s project webpage. For more information, contact your BKD advisor.