Preparing for the Proposed New FASB Lease Accounting Standards
While the new accounting standards will provide more financial transparency, they may lead to a false picture of a firm’s financial health.
David Kamen, Vice President, Global Portfolio Strategy, Global Workplace Solutions, Johnson Controls and Ron Zappile, Manager, Strategic Real Estate Consulting Services, Johnson Controls (Q1 / Winter 2013)
The Financial Accounting Standards Board (FASB) has been developing a global accounting standard to increase the visibility of companies’ lease liabilities to investors. This means that the way that corporations report leased assets will fundamentally change — and that includes the way that they report real estate leases. Not only will the new standard create a significant accounting issue, but it will also require corporate real estate teams to capture and report information about their leased portfolios. The final rules are expected to be announced this coming summer, and corporations will be required to report to that standard beginning in 2015 or 2016.
In order to provide this needed financial transparency, FASB has proposed that the majority of leased assets no longer be reported as operating leases. Therefore, these assets should be hidden from investors as part of monthly profit and loss expenditure, as a so-called off-balance sheet debt.
While this debt may not be apparent by analyzing a company’s financial statements, it is real and could lead to a serious overestimation of a company’s financial health. According to a 2005 Securities and Exchange Commission (SEC) report, off-balance sheet operating lease debt amounts to $1.25 trillion for all U.S. financial statement issuers. Therefore, FASB has proposed changes that would affect a wide range of companies’ expenses and leases, including the real estate assets. In short, once the accounting changes take effect, companies’ perceived debt in their accounting statements could increase enormously.
The Current Situation
Today, real estate leases are categorized as either operating leases or capital leases. The majority are operating leases and booked as a rent expense on the tenant’s income statement. From an investor’s or lender’s perspective, however, this future debt is currently not recognized on the company’s balance sheet.
In 2012, FASB met with the International Accounting Standards Board (IASB) to classify how various leases should be reported. While a definitive answer has not been decided, it appears that all long-term leases, or those more than one year in length, will appear in some form or another on companies’ balance sheets. On the whole, leases of property would be straight-line leases, meaning they will require equal payments spread out over the lifetime of the lease.
Many have argued that transferring these obligations to the balance sheet will affect financial ratios, which could ultimately impact borrowing rates and cash flow. It has also been widely contested that these changes could create a rise in demand for short-term leases because of their continued exclusion from the balance sheet.
This would be a negative for both the lessor and lessee. Lessees demanding short-term leases would pay a premium for the flexibility of short-term agreements, while lessors would lose the security of long-term agreements and this could result in a lack of investment in the upkeep of their property.
Time to Prepare
Once the final rules are announced this summer, there will not a lot of time to prepare before they take effect in 2015 or 2016. To plan for the new lease accounting standards, companies can consider the following tips.
- 1.Capture essential data for all leases. The critical information that should be recorded for all leases includes, but is not limited to, lease commencement and expiration dates, option notification dates and terms, rent and income escalations, additional rent contingencies, security deposit and tenant allowance information, and any landlord-provided incentives, including free rent and tenant improvements.
- 2. Validate processes. Companies will be required to capture the above lease information and review their assumptions on a quarterly basis. Ensure that the lease abstraction process — from lease to lease abstract to insertion into the intelligent software system — is complete and robust. Use dry runs to ensure items are not missed and to identify system enhancements. Employ the same activities to test your 10K reporting and make sure the balance sheet and annual reports production process is sound. A helpful way to analyze these processes may be to develop organizational process maps for large lease portfolios.
- 3. Take advantage of intelligent software. Use real estate management software that is capable of producing the necessary calculations and can integrate with your existing enterprise resource planning systems. These systems tie multiple databases together to produce seamless total cost of occupancy reporting. A strong real estate portfolio database tracks the details from operations, then feeds high-level detail into a financial database so that expenses may be processed, revenue can be invoiced, and charge-backs assessed. This provides the foundation for total cost of occupancy reporting and planning.
- 4. Make data accessible. Provide access to data and reporting that supports your company’s response to and readiness for the new rules. While a client’s financial component of an enterprise resource planning (ERP) system will provide all necessary FASB and IASB reporting, it is important that the real estate system, as part of a total ERP package, can capture the essential data for historical and forecasting purposes. These real estate systems capture the details required for reliable executive support system reporting and effective company decision-making.
- 5. Analyze the situation. Assess the impact of the new lease accounting standards on the value of the company’s lease obligations on a capitalized basis. This is done by calculating the total cash payments of leases, any anticipatory changes in the total lease term length and the imputed interest expense, and then repaying the costs over the anticipated length of the lease.
Click here to find out how this process can be completed.
- 6. Communicate. As with any new processes — especially those with visibility to management, the board of directors, and outside investors and analysts — it is important to minimize the impact of frequent and constant communication within the organization. Work with the accounting or finance teams collaboratively to make the process more relevant to the overall corporate initiatives and to raise awareness and validate the importance of the real estate group in this opportunity.
More Developments to Come
It is important to realize that FASB continues to debate numerous aspects of the proposed new lease accounting standards. It is possible that significant changes may still occur before the final standard is issued. Companies should continue to pay attention to updates and developments in early 2013.