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Introduction:
The Financial Accounting Standards Board (FASB) issued its “Exposure Draft” on August 17, 2010, which requires companies to record nearly all leases on their balance sheets as “right to use” assets, and A “future lease payment liability”. What does this mean for your business in layman’s terms? This proposal summarily eliminates operating leases; All leases (unless immaterial) shall be capitalized using the present value of the minimum lease payments. Therefore, businesses that had off-balance sheet lease obligations in the past must now record these obligations on their balance sheets.
An important point to consider with respect to the proposed lease accounting changes is that, in all likelihood, existing operating leases signed prior to implementation of the new rules will require reclassification as capital leases, which must be accounted for on the balance sheet. . This means that real estate professionals must immediately consider the impact that existing and planned leases will have on their financial statements after the proposed regulations go into effect. Since operating lease obligations can represent a larger liability than all balance sheet assets combined, a lease reclassification can significantly change a business’s balance sheet.
The effect of recording these lease obligations on the balance sheet can have many effects, such as: Businesses need to alert their lenders because they will now be non-compliant with their loan covenants, due to restructured financials with lenders. Negotiating new loan covenants will adversely affect the statements, ratios used to evaluate the business viability of credit and may result in a lower equity balance, as a restatement of a lessee’s financial statement once the changes take effect, And various accounting ratios may change.
The conceptual basis for lease accounting will change from determining that “substantially all the benefits and risks of ownership” have been transferred, to recognizing the “right to use” between the lessor and the lessee as an asset. and to divide the assets (and liabilities).
As part of FASB’s announcement, the board stated that in their view “current accounting in this area does not clearly delineate the resources and obligations arising from lease transactions.” This suggests that the end result will require more leasing activity on the balance sheet than is currently the case. In other words, many, perhaps nearly all, of the leases now considered operating may be considered capital under the new standards. Thus, many companies with large operating lease portfolios are likely to see a material change in their corporate financial statements.
Part of its purpose is to coordinate 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 substantial differences in their treatment of leases; Of particular note is that FAS 13’s “bright line” test (whether the lease term is 75% or more of the economic life, and the present value of the rent is 90% or more of the fair value) is not used by the IASB. , which prefers a “facts and circumstances” approach, which involves more judgment calls. Although both have the concept of capital (or finance) and operating leases, a dividing line is drawn between such leases.
The FASB will be accepting public comments on this proposed change until December 15, 2010. If the FASB makes a final decision regarding the proposed changes to lease accounting in 2011, the new rules will take effect in 2013.
Additionally, the Securities and Exchange Commission staff reported in a report mandated under Sarbanes-Oxley that the amount of operating leases that are excluded from the balance sheet is estimated at $1.25 trillion that would be transferred to the corporate balance sheet if It has adopted the proposed accounting changes.
commercial real estate:
The impact on the commercial real estate market will be substantial and will have a significant impact on commercial tenants and landlords. David Nebiker, Managing Partner of Protent (a commercial real estate firm focused on helping Denver and regional companies strategize, develop and implement long-term, comprehensive facility solutions) said, “This proposed change will not only benefit tenants and affects landlords, rather than brokers, as it increases the complexity of the lease agreement and provides a strong incentive for tenants to execute short-term leases”.
Short term leases create financing issues for property owners as lenders and investors prefer longer term leases to secure their investments. Therefore, landlords should secure financing to purchase or refinance prior to the implementation of this regulation, as financing will be much more difficult in the future.
This accounting change will increase the administrative burden on companies and effectively eliminate the leasing premium for single tenant buildings. John McAslan, a partner at Protent, said: “The impact of this proposed change will have a significant impact on leasing behaviour. Lessees of single tenant buildings will be asking themselves why not just own the building, if I have to include it in my financial statements anyway. to enter?
Under the proposed rules, lessees would have to cash out the present value of nearly all “potential” lease obligations on the corporate balance sheet. The FASB views leasing as essentially a form of financing in which the landlord lets a tenant use a capital asset, in exchange for a lease payment that includes principal and interest similar to a mortgage.
David Nebiker said, “Regulators have missed the point of why most businesses lease and that is for flexibility as their workforce expands and contracts, as location needs change, and Businesses would rather invest their cash in producing revenue growth than in owning real estate.”
The proposed accounting changes will also affect landlords, especially those businesses that are publicly traded or have public debt with audited financial statements. Mall owners and trusts will need to analyze the terms of occupancy and contingent lease rates for each tenant located in their buildings or malls.
Active landlords, tenants and brokers need to familiarize themselves with the proposed standards that may take effect in 2013 and begin negotiating leases accordingly.
conclusion:
The end result of this proposed lease accounting change is a greater compliance burden for the lessee because all leases will have a deferred tax component, will be carried on the balance sheet, will require periodic revaluation and may require more detailed financial statement disclosure. .
Therefore, lessees need to know how to structure and sell transactions that will be desirable to lessees in the future. Many lessees will realize that the new rules take away the off balance sheet benefits formerly provided by FASB 13, and will determine leasing as a less profitable option. They may also see the new standards as being over-burdened and complex and revealing. Ultimately, it will become a challenge for every lessee and commercial real estate broker to find a new approach to marketing commercial real estate leases that makes them more attractive than owning them.
However, this proposed accounting change in FAS 13 could potentially encourage a shortfall in the commercial real estate market in 2011 and 2012 as businesses chose to purchase property rather than deal with lease administrative issues in 2013 and beyond.
Finally, it is recommended that landlords and tenants prepare for this change to avoid potential financial surprises by reviewing their leases with their commercial real estate broker and discussing the financial impact with their CFO, external accountant and tax accountant. Started the preparation. are adopted.
Both David Nebiker and John McAslan of Protent indicated that their entire corporate team is continually educating itself and actively advising its customers about these potential changes.
Appendix – Definition of capital and operating leases:
The basic concept of lease accounting is that some leases are simply rentals, while others are effectively purchases. As an example, if a company rents office space for one year, the value of the space at the end of the year is roughly the same as when the lease began; The company is only using it for a short period of time, and it is an example of an operating lease.
However, if a company leases a computer for five years, and at the end of the lease the computer becomes almost worthless. The lessee (the company receiving the lease payment) anticipates this, and charges the lessee (the company using the asset) the lease payment which will recover all the costs of the lease including profit. This transaction is called a capital lease, although it is essentially a purchase with a loan, since such an asset and liability must be recorded on the lessee’s financial statements. Essentially, the capital lease payment is considered a repayment of the loan; Depreciation and interest expense, rather than lease expense, are then recorded on the income statement.
Operating leases typically have no impact on a company’s balance sheet. However, there is one exception. If a change in lease payments is stipulated in a lease (for example, a planned increase for inflation, or a lease holiday for the first six months), then rent expense is to be recognized on an accrual basis over the life of the lease. The difference between the lease expense recognized and the lease actually paid is treated as a deferred liability (for the lessee, if the lease is increasing) or an asset (if decreasing).
Future minimum lease commitments, whether capital or operating, should also be disclosed as a footnote in the financial statements. The lease commitment must be apportioned by year for the first five years, and then all remaining rents are combined.
A lease is capital if any one of the following four tests is met:
1) the lease confers ownership on the lessee at the end of the lease term;
2) The lessee has the option to purchase the asset at a fair price at the end of the lease term
3) The term of the lease is 75% or more of the economic life of the asset.
4) The present value of the rent, using the lessee’s incremental lending rate, is 90% or more of the property’s fair market value.
Each of these criteria, and their components, are described in greater detail in FAS 13 (section L10 of the FASB current text or codified as ASC 840 of the Codification).
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