New Lease Accounting Will Impact Banks’ Balance Sheets

8/5/2010

By David J. Bayens, CPA

The FASB and IASB have undertaken a joint project, the objective of which is to create common accounting requirements for leases.

Currently, under U.S. GAAP, a lease is evaluated to determine whether it is an operating lease or a capital lease. Evaluation criteria include the length of the lease in relation to the economic life of the property, the amount of the lease payments in relation to the value of the property and other factors. For the lessee, if the conclusion is that it’s an operating lease, rental payments are expensed and there is no balance sheet effect. If it is deemed to be a capital lease, an asset is recorded on the balance sheet along with a liability for the lease payments. Accounting guidelines for leases have been very much “rules-based” and, very often, leases could be structured to avoid capitalization.

Under the proposed new pronouncement, lessees will be required to capitalize virtually all leases. An asset would be recorded based on a “right-of-use” approach. The initial measurement of this amount will be the present value of the lease payments plus any initial direct costs incurred. The liability for the lease obligation will be the present value of the lease payments. It is presently contemplated that existing leases will need to be capitalized as of the effective date of the pronouncement based on the remaining lease obligations. There will be guidance for lease options, sale and leaseback transactions, leases in business combinations and other matters. Not surprisingly, footnote disclosures will be beefed up.

An exposure draft on leases is expected to be issued during the third quarter of this year, and it is expected to be finalized during the first half of 2011. The proposed effective date has not yet been published.

The new lease accounting rules will impact companies in many industries. For some loan customers, the recording of lease obligation liabilities could throw them into violation of loan covenants related to debt levels.

For some banks the affect of this accounting change may be significant. Under the current rules, land leases were virtually never capitalized, and leases for buildings, such as branch facilities, could often be structured as operating leases. With the new rules, the value of these leases will be added to the carrying value of other fixed assets on the balance sheet.

From a regulatory standpoint, the “grossing-up” of the balance sheet through capitalization of leases will negatively impact risk-based capital ratios. Also, the higher levels of fixed assets may exceed what may be allowable under federal and state banking laws. We recommend that banks begin planning for the impact of these new lease accounting requirements.