Lease accounting changes proposed by the FASB – impact on commercial real estate

Introduction:

The Financial Accounting Standards Board (FASB) published its “Exposure Draft” on August 17, 2010, which requires companies to recognize almost all leases on their balance sheets as a “right-of-use asset” and a corresponding “future lease payment – liability”. . What does that mean in layman’s terms for your business? This proposal essentially eliminates operating leases; All leases (unless immaterial) would be capitalized at the present value of the minimum lease payments. As a result, entities that historically had off-balance sheet lease obligations must now recognize those obligations on their balance sheet.

An important consideration to consider in relation to the proposed lease accounting changes is that in all likelihood existing operating leases signed prior to the implementation of the new rules will require reclassification as capital leases to be included in to be accounted for in the balance sheet. This means real estate professionals must immediately consider the impact that existing and proposed leases will have on financial statements once the proposed rules are implemented. Because operating lease obligations can represent a greater liability than all of the balance sheet assets combined, the reclassification of leases can change the entity’s balance sheet significantly.

The accounting for these lease obligations can have several effects, such as: B.: Companies needing to warn their lenders that they are now breaching their loan covenants, negotiating new loan agreements with lenders due to adjusted financial balance sheets, metrics used to assess a company’s credit potential being adversely affected, and the Restating a lessee’s financial statements after the amendment is effective may result in lower equity and changes in various accounting measures

The conceptual basis for accounting for leases would shift from determining when “substantially all the risks and rewards of ownership have passed” to recognizing the “right-of-use asset” as an asset and dividing assets (and liabilities) between lessees and lessor change.

As part of the FASB’s announcement, the Board noted that, in its view, “current accounting in this area does not clearly reflect the resources and obligations arising from lease transactions.” This suggests that the bottom line will likely require more leasing activity to be reflected on the balance sheet than is currently the case. In other words, many, perhaps virtually all, leases that are now considered operational will likely be considered capital under the new standards. As a result, many companies with large operating lease portfolios are likely to see a significant change in their financial statements.

This includes aligning lease accounting standards with the International Accounting Standards Board (IASB), which sets accounting standards for Europe and many other countries. The IASB and FASB currently have significant differences in the treatment of leases; Of particular note is that the “bright line” tests of FAS 13 (whether the lease term is 75% or more of the economic life and whether the present value of the leases is 90% or more of the fair value) are not used by the IASB, who prefers a “facts and circumstances” approach that involves more discretionary decisions. However, both have the concept of capital (or finance) and operating leases, but drawing the dividing line between these leases.

The FASB is accepting public comment on this proposed change until December 15, 2010. When the FASB makes a final decision on this proposed lease accounting change in 2011, the new rules will become effective in 2013.

In addition, in a report commissioned by Sarbanes-Oxley, employees of the Securities and Exchange Commission reported that the amount of off-balance sheet operating leases is estimated at $1.25 trillion, which under this proposed accounting in the company balance sheets would be transferred change assumed.

Commercial real estate:

The impact on the commercial real estate market would be significant and will have a significant impact on commercial tenants and landlords. David Nebiker, Managing Partner of ProTenant (a commercial real estate company focused on helping Denver and regional businesses strategize, design and implement long-term, comprehensive building solutions), added, “This proposed change will not only impact tenants and Weed out landlords, weed out agents as it increases the complexity of leases and gives tenants a strong incentive to sign shorter leases.”

The shorter-term leases pose financing problems for property owners as lenders and investors prefer longer-term leases to secure their investment. Landlords should therefore secure purchase or refinancing financing before this regulation comes into force, as financing will become considerably more difficult in the future.

This accounting change will increase administrative burdens for companies and will effectively eliminate the lease premium for single tenant buildings. Added John McAslan, Associate at ProTenant, “The impact of this proposed change will have a significant impact on rental behavior. Landlords of single tenant buildings will ask themselves why not just own the building when I have to report it in my financial statements anyway? “

Under the proposed rules, tenants would have to capitalize the present value of virtually all “probable” rental obligations on company balance sheets. Essentially, the FASB views leasing as a form of financing in which a lessor allows a lessee to use an asset in exchange for a lease payment that includes principal and interest, similar to a mortgage.

David Nebiker said: “Regulators have missed the point as to why most companies lease, for flexibility as their workforce grows and shrinks as location changes and companies would rather invest their money in achieving revenue growth , than owning real estate. “

The proposed accounting changes will also affect landlords, particularly companies that are publicly traded or have public debt with audited financial statements. Mall owners and trusts need to conduct analytics for each tenant in their building or mall, analyzing the terms of use and contingent rental rates.

Forward-thinking landlords, tenants and agents need to familiarize themselves with the proposed standards, which could come into force in 2013, and begin negotiating leases accordingly.

Conclusion:

The end result of this proposed lease accounting change is greater compliance burden for the lessee as all leases have a deferred tax component, are recognized on the balance sheet, require periodic remeasurement and may require more detailed financial statement disclosures.

Therefore, lessors need to know how to structure and sell transactions that will be desirable to lessees in the future. Many lessees will find that the new rules will negate the off-balance sheet benefits that FASB 13 has historically given them and will make leasing a less favorable option. They may also view the new standards as more cumbersome and complicated to account for and disclose. Eventually, it becomes a challenge for every landlord and commercial real estate agent to find a new approach to marketing commercial real estate leases that makes them more attractive than owning.

However, this proposed accounting change from FAS 13 could potentially stimulate a weak commercial real estate market in 2011 and 2012 as companies chose to buy real estate rather than deal with the administrative issues of leasing in 2013 and beyond.

Finally, it is recommended that landlords and tenants begin preparing for this change by reviewing their leases with their commercial real estate agent and discussing the financial implications with their CFO, external accountant and tax advisor to avoid potential financial surprises if/when accounting changes are accepted.

ProTenant’s David Nebiker and John McAslan both said their entire corporate team is continuously learning and proactively advising their customers on these potential changes.

Addendum – Definition of Capital and Operating Leases:

The basic concept of lease accounting is that some leases are simply rentals while others are effectively purchases. For example, if a company leases office space for a year, the space at the end of the year is worth almost as much as it was when the lease began; The company only uses it for a short period of time and this is an example of an operational lease.

However, if a company leases a computer for five years, the computer is almost worthless at the end of the term. The lessor (the company that receives the lease payments) expects this and bills the lessee (the company that uses the asset) a lease payment that covers all costs of the lease, including a profit. This transaction is known as a finance lease, but is essentially a purchase with a loan since such an asset and liability must be recognized in the lessee’s financial statements. Basically, the Capital Lease payments count as repayment of a loan; Depreciation and interest expense are then recognized in the income statement instead of lease expense.

Operating leases do not typically affect a company’s balance sheet. However, there is one exception. When a lease includes scheduled changes in the lease payment (e.g., a planned increase in inflation or a lease vacation for the first six months), rental expense is recognized evenly over the lease term. The difference between the recognized lease expense and the lease actually paid is considered an accrued liability (for the lessee if the leases increase) or an asset (if they decrease).

Whether capital or operating expenses, future minimum lease obligations must also be disclosed as a footnote in the financial statements. The rental obligation must be broken down by year for the first five years, after which all remaining rents are totaled.

A lease is capital when one of the following four tests is met:

1) The rental agreement transfers ownership to the tenant at the end of the rental period;

2) The lessee has the option to purchase the asset at the end of the lease term at a bargain price

3) The lease term is at least 75% of the economic useful life of the asset.

4) The present value of the leases is 90% or more of the fair value of the asset using the lessee’s incremental borrowing rate.

Each of these criteria and their components are described in more detail in FAS 13 (codified as Section L10 of the FASB Current Text or ASC 840 of the Codification).