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FASB Proposed Lease Accounting Changes – Impacts on Commercial Real Estate
The Financial Accounting Standards Board (FASB) issued its “Exposure Draft” on August 17, 2010 requiring companies to record on their balance sheets “right-of-use” assets and related “future lease payments – liabilities”. . What does this mean for your business in layman’s terms? The proposal essentially eliminates operating leases; All leases (unless intangible) are capitalized using the present value of the minimum lease payments. Therefore, businesses that previously had off-balance sheet lease obligations 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 the implementation of the new rules will require reclassification as capital leases that must be accounted for on the balance sheet. This means that real estate professionals must immediately consider the impact of existing and planned leases on their financial statements after the proposed rule goes into effect. Since operating lease obligations can represent a larger liability than all balance sheet assets combined, lease reclassification can significantly alter a businesses balance sheet.
The impact of recording these lease obligations on the balance sheet can have many consequences, such as: businesses need to warn their creditors that they will no longer honor their loan agreements, negotiating new loan agreements with lenders due to repositioning financial statements, ratios used to assess the business’s potential for credit There will be an adverse effect and the restatement of the lessee’s financial statements once the change is implemented may result in a decrease in the equity balance and changes in various accounting ratios.
The conceptual basis of lease accounting will change from determining when “all benefits and risks of ownership” are transferred, to recognizing “right-to-use” assets and apportioning assets (and liabilities) between the lessee and the lessee.
As part of the FASB’s announcement, the board stated that in its opinion “current accounting in this area does not accurately depict the resources and liabilities arising from lease transactions.” This suggests that the bottom line will need to reflect more leasing activity on the balance sheet than is currently the case. In other words, many, perhaps virtually all, leases now considered operating are likely to be considered capital under the new standards. Thus, many companies with large operating lease portfolios are likely to experience significant changes in their corporate financial statements.
Part of the 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 differ significantly in their treatment of leases; Of particular note is that FAS 13’s “bright line” tests (whether the lease term is 75% or more of the economic life and the present value of the lease is 90% or more of fair value) are not used. The IASB, which prefers a “facts and circumstances” approach that involves more judgment calls. However, both have the concept of capital (or finance) and operating leases, although a dividing line is drawn between such leases.
The FASB will accept public comments on this proposed change until December 15, 2010. If the FASB makes a final decision on this proposed change to leases 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 off-balance sheet operating leases is approximately $1.25 trillion that would be transferred to corporate balance sheets if this accounting were proposed. Change is accepted.
Commercial Real Estate:
The impact on the commercial real estate market will be significant and will have a significant impact on commercial tenants and landlords. David Nebiker, managing partner of ProTenant (a commercial real estate firm focused on helping Denver and regional companies plan, develop, and implement long-term, comprehensive amenity solutions) added, “This proposed change doesn’t just affect tenants and landlords. Brokers because it It increases the complexity of the lease agreement and provides a strong incentive for tenants to operate short-term leases”.
Short-term leases create financing problems for property owners as lenders and investors prefer long-term leases to secure their investments. Therefore, landlords should secure financing for purchases or refinances prior to the implementation of this regulation, as financing will become more difficult in the future.
This accounting change will increase the administrative burden on companies and effectively eliminate the lease premium for single tenant buildings. John McAslan, associate at ProTenant added “The impact of this proposed change will have a significant impact on leasing behaviour. Tenants of single tenancy buildings will ask themselves if I have to record it in my financial statements, why not just the building?”
Under the proposed rules, lessees would have to capitalize the present value of virtually all “potential” lease obligations on the corporate balance sheet. The FASB views a lease essentially as a form of financing in which the lessee is letting the lessee use a capital asset, including principal and interest, as in the case of a mortgage.
David Nebiker said, “Regulators have missed why most businesses lease and that is for flexibility as their workforces grow and contract, because of the need to relocate, and businesses will invest their cash in revenue growth rather than owning real estate.”
The proposed accounting changes will also affect landlords, especially businesses that are publicly traded or have public debt with audited financial statements. Mall owners and trusts need to analyze each tenant in their building or mall, analyzing the terms of occupancy and contingent lease rates.
Active landlords, tenants and brokers should familiarize themselves with the proposed standards, which could come into effect in 2013, and negotiate leases accordingly.
The end result of this proposed lease accounting change is a greater compliance burden for lessees because all leases will have a deferred tax component, be placed on the balance sheet, require periodic revaluations, and require more detailed financial statement disclosures.
Therefore, tenants need to know how to structure and sell deals that will be desirable to tenants in the future. Many lessees will find that the new rules will take away the off-balance sheet benefits that FASB 13 previously gave them and make leasing a less profitable option. They may also see the new standards as more cumbersome and complicated account disclosure and disclosure. Ultimately, it will be a challenge for every tenant and commercial real estate broker to find new approaches to marketing commercial real estate leases that make them more attractive than ownership.
However, this proposed accounting change in FAS 13 could fuel a downturn in the commercial real estate market in 2011 and 2012 as businesses decide to purchase properties rather than deal with the administrative issues of leases in 2013 and beyond.
Finally, it is recommended that landlords and tenants begin preparing for this change by reviewing their leases with their commercial real estate broker and discussing this change with their CFO, external accountant and tax accountant to avoid potential financial surprises if the accounting changes. are adopted.
Both David Nabiker and Protenant’s John McAslan indicated that their entire corporate team is constantly educating themselves and actively advising their customers about these potential changes.
Appendix – Definition of Capital and Operating Lease:
The basic concept of lease accounting is that some leases are simply leases, while others are effectively purchases. For example, if a company leases office space for a year, the cost 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 this is an example of an operating lease.
However, if a company leases a computer for five years and the computer is almost worthless at the end of the lease. The lessee (the company that receives the lease payments) estimates and the lessee (the company that uses the asset) charges the lease payments that will recover all lease costs, including profits. This transaction is called a capital lease, however it is essentially a purchase with a loan, as such assets and liabilities must be recorded on the lessee’s financial statements. Essentially, capital lease payments are considered repayments of debt; Depreciation and interest expense, rather than lease expense, are then recorded on the income statement.
Operating leases usually do not affect a company’s balance sheet. But there is an exception to this. If the lessee makes changes to the lease payments (for example, a planned increase for inflation or a lease holiday for the first six months), the lease expense should be recognized over the life of the lease on an equal basis. The difference between the lease expense recognized and the lease actually paid is considered a deferred liability (for the lessee, if the lease is increasing) or an asset (if it is decreasing).
Future minimum lease commitments, whether capital or operating, must also be disclosed as a footnote in the financial statements. The lease commitment must be broken down year by year for the first five years and then all remaining rents will be consolidated.
A lease is capital if any of the following four tests are met:
1) confers ownership on the lessee at the end of the lease term;
2) The lessee has an option to purchase the asset at the end of the lease term at a bargain price
3) The lease term is 75% or more of the economic life of the asset.
4) The present value of the rent, using the tenant’s incremental borrowing rate, is 90% or more of the property’s fair market value.
Each of these criteria, and their components, are described in more detail in FAS 13 (codified as Section L10 of the FASB Current Text or ASC 840 of the Codification).
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