The Financial Accounting Standards Board is getting closer to finalizing changes to lease accounting standards that could have a significant impact on lease obligations and profit-and-loss reporting for commercial entities. Analysts at the Securities and Exchange Commission estimate that as much as $1.3 trillion in liabilities could be shifted back onto balance sheets, a huge change in the corporate leasing landscape. Experts expect that the changes will have significant costs as companies take on the additional accounting burden, but the real question is how the changes will impact commercial real estate business decisions. For more on this continue reading the following article from National Real Estate Investor.
The Financial Accounting Standards Board (FASB) is one step closer to implementing new lease accounting standards that have been in the works for nearly five years.
“This has been a long running saga that doesn’t have a defined ending to it quite yet,” says Richard Kadzis, a vice president at CoreNet Global, an Atlanta-based association for corporate real estate professionals. FASB released its second Exposure Draft on Lease Accounting rules last month. The latest round of revisions for proposed lease accounting rules is a bit more palatable for companies that occupy commercial real estate space.
The proposed lease accounting changes have drawn widespread criticism from the commercial real estate industry as well as businesses that occupy space. The Securities & Exchange Commission has estimated that the new lease accounting guidelines would move $1.3 trillion in lease liabilities that previously received off-balance sheet treatment back onto balance sheets. Approximately 70 percent of that volume is from real estate leases.
The latest revisions attempt to respond to some of the concerns that companies raised during earlier comment periods. For one, FASB now says that it is going to allow lessees to recognize rent expenses as they are today, which is on a straight-line basis. The original proposal would have required tenants to use the "effective interest method" to amortize lease liabilities while right-of-use assets were going to be amortized based on straight-lining. The combination of the two methods would have created a bigger impact on profit-and-loss (P&L) reporting, particularly for companies that have formidable lease liabilities.
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“That is an important change, because if you look at a retailer such as Walgreens or McDonald’s that have sizable lease obligations, they were facing a potentially big hit to their P&L,” says Mike Schmitt, CPA, a financial advisor on the Tenant Advisory Team for Cassidy Turley in Cincinnati. For example, Walgreens’ lease liabilities amount to about $35 billion, while McDonald’s has an estimated lease exposure of about $10 billion, notes Schmitt.
The new draft also addresses questions related to how to account for renewal options. The original proposal said that the lessee would have to count the “longest period likely to occur than not” when calculating lease liability. “That was confusing to a lot of people,” notes Schmitt. If a tenant has a 10-year lease with two 5-year options to renew, it was unclear whether that should be valued as a 10-year lease, a 15-year lease or a 20-year lease. FASB has since changed that language to say that a lessee only has to include the renewal terms if there is “significant economic incentive” to exercise those renewal options.
Gauging the impact
The big wild card for the commercial real estate industry is how, if at all, the new accounting rules will impact decision making related to commercial real estate. Initially, the bigger focus for companies will be on how to deal with the added accounting burden. “There are still some people who are objecting to how complicated this is,” says Schmitt. It is going to be a huge undertaking for accounting departments to figure out the new rules and calculate the liabilities, he adds.
Lease accounting changes are just one of the many different issues that CFOs are addressing in the post-recession economy, agrees Kadzis. Another concern is whether all of that money being moved back on balance sheet will hurt economic growth, he adds.
In addition, there are a lot of business loans that have debt covenants that could be triggered by lease accounting changes and changes to balance sheets. Effectively, these alterations could place some corporate borrowers in violation of loan covenants. The question is whether bankers will hold borrowers in default, or view the changes as technicalities. Earnings before interest, taxes, depreciation and amortization (EBITDA) also will be impacted by the proposed lease accounting standards. “So, the whole financial world is going to have to recalibrate,” says Schmitt.
More changes ahead?
A key driver behind the proposed changes is that the SEC wants to eliminate off-balance sheet financing arrangements and create greater transparency in financial reporting. There is broad support for greater transparency. It’s the pain of getting there that has many worried. “We will have a better, truer understanding of our assets. That being said, companies?both big and small?still have a list of concerns related to the proposed changes and how it will impact their business,” says Kadzis.
One of the issues still being debated is whether the proposed changes will go into effect across the board, of if FASB will make some exceptions for smaller, private companies. “There is a recognition and acknowledgement on FASB’s part that some of these rules are pretty onerous, especially for smaller companies, and they don’t really move the needle as far as their financial statements,” says Schmitt. Critics also are questioning the cost/benefit to the financial statement changes is worthwhile.
Initially, the proposed accounting change drew a backlash of criticism. Now it is seen as an inevitable change that most companies have come around to accepting. “I think we are conditioning ourselves to manage around any potential new regulation that may end up being an international standard,” says Kadzis.
The current exposure draft is open for public comment through September 13, 2013. After reviewing responses, FASB is expected to produce a final release some time in 2014. Implementation of the new standards is likely to be phased in between 2015 and 2017.
This article was republished with permission from National Real Estate Investor.
