September 17, 2012

New Lease Accounting Rules

Craig Trbovich Commercial Real Estate Update

In 2010, the U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) proposed a major change in accounting for long-term operating leases, requiring those obligations to be recorded as liabilities. These leases are currently reported only as expenses when due (e.g. on a monthly basis) with no liability being reported related to the future obligation remaining. On June 13, 2012, the two Boards met to address comments and revisions to the new rules.

There are naturally questions and concerns about how the proposed changes will affect commercial real estate. Lessors and lessees need to be familiar with the new rules because there may be severe consequences: estimates of $1 trillion in new liabilities to be recorded by companies, of $1 billion to implement the change, and these negative impacts on balance sheets could cost thousands of jobs.

For lessees, the June meeting primarily dealt with technical accounting and reporting mechanics, leaving the major requirement to record operating leases as liabilities on lessees’ balance sheets intact. Recording this debt, especially for large retail chains with multiple lease locations, could have a significant impact on financial statements and decision making.

Some companies are already beginning to prepare for this by reducing lease terms and going to multiple one year options. Walgreens, for example, operates more than 7,500 drugstores in the United States. They are trying to move away from 25 year guaranteed lease terms and 5 year options to 20 year of guaranteed terms with the option periods in one year increments, which would be exempt from the new rules.

For lessors, however, a big change from the original version has been made. Investment Property Entities will be allowed to record most leases under the old rules, when the income is due. Even though their accounting procedures will not change, the uncertainty and risk associated with the threat to tenants, especially if shorter term leases is the result, has the potential to negatively impact property values and borrowing capacities. (In a related project, the FASB is developing a new standard to record most investment real estate properties at fair values.)

How do you prepare for significant changes like this? Be informed. Talk to your chief financial officers, outside accountants, tax advisors and legal counsel. Consider the impact of the new rules on your financial reporting and the resources needed to comply with the standards. As a tenant, consider what will be the impact as you analyze future leases. As an investor, consider how you will handle the potential impact on tenant leasing decisions and on your own financing decisions.

The Boards expect to issue another draft later this year and issue the final version in 2013 with possible implementation in 2015. However, in May, 60 members of Congress wrote a letter to the FASB urging a “careful rethinking” of the proposed rule changes and warning of “disastrous consequences”. In that letter, the members recommend a thorough study of the impact of the new rules. Keep monitoring the progress of the rules and provide comments to FASB, either individually or through your associations.

(Craig Trbovich, CPA is a commercial real estate advisor with Commercial Properties, Inc.)

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