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The Cost of Your Lease Just Increased, Without Your Landlord Increasing Rent
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Published: July 13, 2011
Authors:
Bruce Harms and
Charles (Buck) Sweeney
written with Benjamin Weiland
If your business expenses rent payments, its balance sheet will now include significantly more debt after a recent announcement by the Financial Accounting Standards Board and the International Accounting Standards Board. Businesses must now include all lease obligations on their balance sheets as an asset and as a liability. As a result of this announcement, businesses can no longer expense lease payments. Instead, businesses must initially recognize a liability to make lease payments.
In many instances, lease obligations are the single largest long-term liability that businesses have historically left off balance sheets. The asset and liability value of capital leases is determined by a present value calculation which includes base rent, residual payments and renewal options.
Balance sheets must now include future lease liabilities as a long term debt which may adversely affect a business’s ability to access credit. Lease renegotiation is an effective way to reduce your business’s debts after the new announcement.
Here is a simple example that demonstrates how the new rule will harm balance sheets. If a company signs a 5 year, $200,000 per year lease, it must include the rental payments as an asset and a liability. Assuming a discount rate of 5% and no residual payments or options, the company must include $866,000 as an asset and liability on the balance sheet for the first year. Thereafter, the business will deduct the sum of the asset value of the lease ($865,000) on a straight-line basis over 5 years plus the “interest expense” associated with the liability that is carried on the books. The interest expense is calculated in much the same way the interest payment of a standard mortgage payment is calculated—more interest in the early years and less in the later years.
The bottom line is that the combined amortization and interest expense will result in a greater lease expense in the early years as compared to the straight-line expense currently reported for typical operating leases.
The timing of this announcement is unfortunate given the economic climate and the restrictive lending practices of banks. Landlords need longer leases to get bank financing; however, tenants will want to negotiate shorter term leases.
For more information on lease accounting or lease negotiations, contact Buck Sweeney at 608.283.6743 or csweeney@axley.com, or Bruce Harms at 608.283.6736 or bharms@axley.com. The authors wish to thank Benjamin Weiland, a law clerk at Axley Brynelson, for his assistance.
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