The Financial Accounting Standards Board (FASB) on August 17, 2010 published its “exposure draft” that requires companies to record nearly all leases on their balance sheets as a “right of use” asset and a “payment. future lease – corresponding liability “. . What does this mean for your business in simple terms? In essence, this proposal eliminates operating leases; all leases (unless intangible) would be capitalized using the present value of the minimum lease payments. Therefore, companies that in the past had off-balance sheet lease obligations must now record these obligations on their balance sheet.
A key point to consider regarding the proposed changes to lease accounting is that, in all likelihood, existing operating leases, signed prior to the implementation of the new rules, will require reclassification as capital leases that need to be accounted for on the balance sheet. . This means that real estate professionals should immediately consider the effect that existing and planned leases will have on the financial statements once the proposed rules are implemented. Because operating lease obligations can represent a greater liability than all balance sheet assets combined, reclassifying the lease can significantly alter the company’s balance sheet.
The impact of recording these lease obligations on the balance sheet can have multiple impacts, such as: companies needing to alert their lenders as they will now default on their loan agreements, negotiate new loan agreements with lenders due to the upgrade financial financial statements, the ratios used to assess the credit potential of a business will be adversely affected and the restatement of a lessee’s financial status once the change takes effect may result in a lower principal balance and changes in various accounting ratios
The conceptual basis for lease accounting would change from determining when “substantially all the benefits and risks of the property” have been transferred, to recognizing the “right of use” as an asset and contributing assets (and obligations) between the lessee and the tenant. lessor.
As part of the FASB’s announcement, the Board stated that, in its opinion, “current accounting in this area does not clearly describe the resources and obligations that arise from lease transactions.” This suggests that the bottom line will likely require more leasing activity to be reflected on the balance sheet than it currently is. In other words, many, perhaps virtually all, leases that are now considered operating will likely be considered equity under the new rules. Therefore, many companies with large portfolios of operating leases are likely to see a material change in their corporate financial statements.
Part of the purpose of this is to coordinate lease accounting standards with the International Accounting Standards Board (IASB), which sets accounting standards for Europe and many other countries. IASB and FASB currently have substantial differences in their treatment of leases; It is particularly notable that the “bright line” tests of FAS 13 (if the lease term is 75% or more of the economic life, and if the present value of the rentals is 90% or more of the fair value) does not they are used by the IASB, which prefers a “facts and circumstances” approach that involves more judgment. Both, however, have the concept of capital (or finance) and operating leases, however, the dividing line is drawn between such leases.
The FASB will accept public comment on this proposed change until December 15, 2010. If the FASB makes a final decision in 2011 regarding this proposed change to lease accounting, the new rules will take effect in 2013.
Additionally, Securities and Exchange Commission staff reported in a report ordered by Sarbanes-Oxley, that the amount of operating leases held off balance sheet is estimated at $ 1.25 trillion that would be transferred to corporate balance sheets if this were to happen. proposed. the accounting change is adopted.
Commercial real estate:
The impact on the commercial real estate market would be substantial and will have a significant impact on commercial tenants and landlords. David Nebiker, Managing Partner at ProTenant (a commercial real estate firm focused on helping Denver and regional companies strategize, develop and implement comprehensive long-term facilities solutions) added “This proposed change doesn’t just affect tenants. and landlords, but intermediaries, as it increases the complexity of leases and provides a strong impetus for tenants to execute short-term leases. “
Short-term leases create financing problems for homeowners, as lenders and investors prefer longer-term leases to secure their investment. Therefore, homeowners must obtain purchase or refinance financing prior to the implementation of this regulation, as financing will be considerably more difficult in the future.
This accounting change will increase the administrative burden on businesses and the rental premium for single-tenant buildings will be effectively eliminated. John McAslan, a ProTenant associate, added that “the impact of this proposed change will have a significant impact on leasing behavior. Landlords of single-tenant buildings will wonder why not just own the building, if I have to register it. in my financial statements anyway. ” “
Under the proposed rules, tenants would have to capitalize the present value of virtually all “probable” lease obligations on corporate balance sheets. The FASB views leasing essentially as a form of financing in which the lessor allows a tenant to use a capital asset, in exchange for a lease payment that includes principal and interest, similar to a mortgage.
David Nebiker said that “regulators have not understood why most companies rent and that is for flexibility as their workforce expands and contracts, as location needs change, and companies prefer to invest their cash in producing an increase in income, rather than owning real estate. “
The proposed accounting changes will also affect owners, especially companies that are publicly traded or have public debt with audited financial statements. The owners of shopping centers and trusts should perform an analysis for each tenant located in their buildings or shopping centers, analyzing the terms of occupancy and contingent lease rates.
Proactive landlords, renters, and brokers should familiarize themselves with the proposed standards that could take effect in 2013 and begin negotiating leases accordingly.
The end result of this proposed change in lease accounting is an increased compliance burden on the lessee, as all leases will have a tax-deferred component, be included on the balance sheet, require periodic reassessment, and may require disclosure. more detailed financial statement.
Therefore, lessors need to know how to structure and sell transactions that will be desirable to tenants in the future. Many tenants will find that the new rules eliminate the off-balance sheet benefits that FASB 13 gave them in the past and will determine that leasing is a less beneficial option. They may also find the new standards more cumbersome and complicated to explain and disseminate. Ultimately, it will become a challenge for every commercial real estate landlord and broker to find a new approach to marketing commercial real estate leases that makes them more attractive than homeownership.
However, this proposed accounting change to FAS 13 could potentially stimulate a lack of shine in the commercial real estate market in 2011 and 2012, as companies decided to buy properties rather than deal with leasing administrative issues in 2013 and beyond. there.
In conclusion, it is recommended that homeowners and tenants begin to prepare for this change by reviewing their lease agreements with their commercial real estate broker and discussing the financial ramifications with their CFO, outside accountant, and tax accountant to avoid potential if / when financial surprises. accounting changes. are adopted.
Both David Nebiker and John McAslan of ProTenant indicated that their entire corporate team is proactively educating and advising their clients on these potential changes.
Annex – Definition of operating and capital leases:
The basic concept of lease accounting is that some leases are simply rentals, while others are actually purchases. For example, if a business rents office space for a year, the space is worth almost as much at the end of the year as it was when the lease began; the business is simply using it for a short period of time, and this is an example of an operating lease.
However, if a business leases a computer for five years, and at the end of the lease, the computer is almost useless. The lessor (the company that receives the lease payments) anticipates this and charges the lessee (the company that uses the asset) a lease payment that will recover all the costs of the lease, including a profit. This transaction is called a capital lease, however, it is essentially a purchase with a loan, since said asset and liability must be recorded in the financial statements of the lessee. Essentially, principal lease payments are considered loan repayments; Depreciation and interest expenses, instead of leasing expenses, are recorded in the income statement.
Operating leases do not normally affect a company’s balance sheet. There is, however, an exception. If a lease has scheduled changes in the lease payment (for example, a planned increase for inflation or a lease holiday during the first six months), the lease expense will be recognized on an equal basis over the life of the lease. The difference between the recognized lease expense and the lease actually paid is considered a deferred liability (for the lessee, if the leases increase) or asset (if they decrease).
Whether capital or operating, future minimum lease commitments should also be disclosed as a footnote in the financial statements. The lease commitment must be broken down by year for the first five years, and then all remaining rentals are combined.
A lease is capital if any of the following four tests are met:
1) The lease transfers ownership to the lessee at the end of the lease term;
2) The lessee has the option to purchase the asset at a bargain price at the end of the lease term.
3) The lease term is 75% or more of the asset’s economic life.
4) The present value of the rents, using the incremental indebtedness rate of the lessee, is 90% or more of the fair market value of the asset.
Each of these criteria, and their components, are described in more detail in FAS 13 (coded as section L10 of the FASB Current Text or ASC 840 of the Codification).