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Implicit Leases: The hidden bombshell in FASB’s new lease accounting December 5, 2010

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting.
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As we approach the December 15th deadline for commenting on FASB’s and IASB’s “Exposure Draft on Leases”, I thought I’d point out a far-reaching implication of the new lease accounting … an implication that has gotten surprisingly little attention.  It’s this: the new standard applies to not just explicit leases, but also to implicit leases.

Now it should be obvious that just because a contract explicitly says “Lease” in its title, does not mean that it is a lease … for any purpose, let alone accounting.  Also, conversely, a contract that does not say “Lease” in its title is not necessarily not a lease.  Under lease accounting, if a contract is or contains an implicit lease for accounting purposes, it’d have to be accounted for, in whole or in part, as a lease.

What-you-don’t-think-is-a-lease but which is a lease in terms of accounting, may surprise you.  The accounting definition of a lease does not conform to any layman’s definition or, for that matter, to any legal definition.  For  example: some types of licenses that give a company the right to occupy space, perhaps as part of a larger contract, are likely to be deemed to be leases for accounting and have to be accounted for as such.   In addition, the new accounting will also apply to service contracts involving equipment, such as photocopy machines.

The implicit-lease issue goes, though, far beyond licenses and equipment-based service contracts.  It will apply to some subcontracts and outsourcing arrangements … contracts that the contracting parties undoubtedly do not now think of as leases.

How’s that?

Appendix B of the Exposure Draft provides the proposed accounting definition of a lease.  It says, in essence, that each and every contract a company signs needs to be evaluated to see if it is or contains a lease.  If the following two characteristics are present, part or all of the contract must be accounted for as a lease:

(a)    the fulfilment of the contract depends on providing a specified asset or assets and

(b)   the contract conveys the right to control the use of a specified asset for an agreed period of time.

The document goes on to provide guidance in addressing these two tests, and you should read this guidance to understand the nuances.  Regarding these two tests as it relates to buildings, (a) a building would be deemed to be specified if the supplier was not able to relocate production to another facility without the customer’s approval, and (b) the building would be deemed to be under the control of the customer if the customer got all but an insignificant amount of the benefit from its use.  While contracts that call for payment on a unit-price basis would probably not be deemed leases, there will still be some types of sub-contracts and outsourcings that will be deemed to have implicit leases embedded in them. 

Consider a contract where Company A outsources logistics to Company B for a period of time and agrees to pay a certain amount each month for the service.  If Company A gets to say in which of Company B’s facilities this work is done and if the work Company B does in that facility is almost all to service Company A, then it is very possible that a portion of that contact will be deemed to be an implicit lease.  The obligation related to that portion would have to be capitalized and put on Company A’s balance sheet; Company B would account for that portion of the contract as a sublease.

This is going to take a lot of companies by surprise, and has an ironic twist.  One of the motivations for many companies who have outsourced work previously done in-house has been the ability to get assets (and related liabilities) off their balances sheets.  Well… surprise, surprise!  Those assets and liabilities may be coming back as a result of the new accounting.

The implicit-lease issue could even hit parts-supply contracts where conditions (a) and (b), above, exist and contract pricing is on a cost-plus-profit basis.  It also may hit energy contracts where a third party installs energy-saving or power-generating equipment, such as solar panels, on a customer’s site and then sells the power to the user.  This could have a big effect on the business models of such third-party suppliers of energy.

In truth, the need to evaluate whether a contract contains an implicit lease is not new; it already is an accounting principle.  Heretofore, though, unless an implicit lease met the conditions that made it a capital lease (which would then have to be put on the balance sheet), the identification of a contract as being or containing an implicit lease was non-material.  This is because operating leases and service contracts have been accounted for similarly … both off-balance sheet.   The “implicit lease test”, therefore, tended not to be applied rigorously.  Now with the new lease accounting putting leases on balance sheet, though, the test as to whether a contract is or contains a lease is far from immaterial.

The implication of applying the new lease accounting standard to implicit leases could be vast.  In theory, every contact signed by a company will have to undergo a “lease test”, just like today every lease needs to undergo a “capital lease test”.  Think of the process implications.  And beyond that, think about how your company might have to re-think strategies surrounding outsourcing and supply-chain management.  This is yet another reason that the new lease accounting has implications far beyond what most people think.

Lease accounting isn’t just for real estate, anymore … and it’s not even just for the-contracts-you-thought-were-leases, anymore.

Click here for more posts on the new lease accounting.

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Comments»

1. Lease Accounting Change Still Coming; Waiting for the Fat Lady to Sing « Corporate Real Estate Strategy - May 15, 2011

[…] sheet, a portion of the projected future payments to be made to the logistics contractor.  See my previous post on this […]


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