A long-anticipated draft of proposed lease accounting changes was released on August 17, 2010 by the U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). By now, most corporate real estate (CRE) executives know of the new paradigm for lease accounting and the impact of putting all leases on the balance sheet. The reality of the proposal is now shifting the focus to potential changes in leasing strategy and practices, as well as meeting requirements for future lease administration.
The draft, known as the Exposure Draft, is the latest step in a lengthy process to require capitalization of all real estate and equipment leases on balance sheets by recognizing the rights and obligations of lessees. Although a 120-day period of public comment follows the Exposure Draft's release, the regulation's core elements will probably not change. A final standard is expected to be issued in mid-2011, with an effective date yet to be determined, but likely no sooner than January 1, 2013.
The perceived lack of transparency regarding off-balance sheet obligations and the complexity of current lease accounting are driving pressure to revamp the three-decades-old leasing standard.
Today, businesses choose from two methods to classify leases: operating or capital leases. Under the new approach, organizations will recognize a liability for obligations to pay rent and a corresponding asset representing the right to use the underlying leased property.
Placing the full lease obligation on the balance sheet - and the resulting negative drag on corporate earnings - will dramatically affect companies' perceived financial performance. Changes in financial reporting will be daunting and cumbersome, as companies must capture new data to support the capitalization of obligations based on internal evaluation of occupancy practices and property use, then regularly re-evaluate those assumptions and adjust income statements and balance sheets accordingly.
How Will Companies Respond?
It's still unknown how companies will react and how significantly they will alter the use of leases and desired lease terms. Companies may react by seeking shorter-term leases or favoring ownership if property use goes on the balance sheet anyway. The changes will certainly push companies to articulate and validate the reasons for leasing, such as flexibility in occupancy and preservation of capital for core business activities.
Given the principles-based approach of the new leasing standard, certain transactions, such as sale-lease backs and build-to-suit arrangements, could be easier to execute. Most importantly, they may be achieved with better economic terms for tenants and better suited to their true business objectives. While the standard setters' concerns about financial engineering of leases frame much of the new approach, these transactions may better align with corporate goals.
The new standard will disproportionately affect business sectors that rely heavily on real estate to generate revenue. Obvious industry candidates are retail, but commercial banking, with its substantial customer service operations, will also see effects. Retailers operating on notoriously thin margins will see net margins erode substantially. The reported increase in occupancy expense for retailers will be exacerbated by a potential tendency to capitalize renewal periods and recognize higher rents under percentage sale arrangements.
Although the transition date has not been released, the sweeping changes in financial reporting will prompt companies to begin planning their adaptations immediately. The immediate demands will be to:
• Assess the suitability of existing lease administration and reporting systems to accommodate the new accounting requirements;
• Plan for enhancement of lease abstracts and processes for additional data capture for existing leases; and
• Create standards for assessment of obligations for lease term, net lease expenses, and contingent rent that will survive audit review.
Impact on Specific Leases
These new lease accounting rules will affect certain transactions in different ways.
Sale-leasebacks - The Exposure Draft offers immediate gain recognition for any properties sold under a sale-leaseback arrangement. However, the proposal incorporates many of the current limitations on continuing involvement of the seller under U.S. Generally Accepted Accounting Principles (GAAP, which are more subjectively evaluated today under International Financial Reporting Standards, or IFRS). These limitations include purchase options other than at fair value, seller financing, and shared appreciation. Any leaseback terms that are not at market price, such as rent, will require an adjustment to the recognized sale value and gain.
Subleases - Whenever a tenant subleases space, an additional asset must be recognized for the rent receivable and a liability for the sub-landlord's performance obligation. This obligation will require the tenant or sub-landlord to make similar decisions about its subtenant's occupancy as it made on its own occupancy. In addition to the primary right-of-use asset and liability, sublease amounts must be recognized, but will be presented on a net basis.
Build-to-suit Leases - The Exposure Draft does not address development arrangements since they relate to the pre-lease period and are not part of lease accounting. However, all leases must be recognized when they are executed, even if the lease period has not begun.
Situations such as statutory leasing provisions, rent reviews, impact on regulated industries, lease modifications, impairment, and deferred tax assets will increase complexity in applying the standard.
Corporate Real Estate's Role
Because property leases represent roughly 70 percent of all operating leases, CRE directors play a key role in this process. In 2005, the Securities and Exchange Commission estimated that U.S. public companies had a capitalized equivalent of $1.3 trillion in operating leases, or approximately $1 trillion in real estate obligations, that must be capitalized.
As the implementation of the new standard approaches, many CRE directors have proactively alerted finance executives at their companies about the changes and likely effects. In recent months, more companies have begun to address the challenge of preparing their existing lease portfolio and reassessing the process for structuring effective leases going forward. This reassessment has four essential components:
1. Understand and quantify the impact by testing how negotiated lease terms drive the balance sheet and operating expense;
2. Communicate with corporate treasury and accounting departments about future changes, decisions, and reporting needs;
3. Anticipate and plan for new financial reporting by identifying additional data acquisition and making changes to lease administration systems; and
4. Re-assess negotiated lease terms and principles for lease-versus-own decision-making.
Sweeping lease accounting changes will give CRE executives an opportunity to support the fundamental business reasons for leasing and to clarify when financial reporting objectives are merely a subsidiary issue. Placing the focus on valued operating flexibility and preservation of capital for core business investment will help organizations navigate the challenging time ahead with new lease accounting.