For the past four years, the Financial Accounting Standards Board (FASB) has been working to change the way tenants and owners of commercial real estate report their lease transactions on financial statements. It now appears we are in the final stretch, and significant changes are coming soon that will have a big impact on the bottom line for many companies. All companies (both public and private) adhering to GAAP standards are subject to the changes.
What is FASB 13?
FASB 13 regulates the accounting standards for office leases in the United States. In effect since 1977, these standards have established how leases are reported on financial statements by both tenants and landlords. (Since Hughes Marino exclusively represents tenants in their lease transactions, and not landlords, we will focus on the new standard from a tenant perspective for the purposes of this article.)
FASB 13 calls for every lease to be classified as either an Operating Lease or a Capital Lease based on specific criteria. As it currently stands, the vast majority of lease transactions are classified as Operating Leases. An Operating Lease is treated as an ongoing operating expense, where a Capital Lease is treated as a financing transaction and should be reported as an asset and liability on a company’s financial statements.
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What’s changing and why does it matter?
The new standards being proposed for FASB 13 will make almost all commercial real estate leases Capital Leases instead of Operating Leases. This means that any company using generally accepted accounting principles (GAAP) will be required to report its lease obligations on its balance sheet as an asset and liability rather than simply an operating expense on the income statement.
As it currently stands, to be considered a Capital Lease a transaction needs to meet certain criteria that basically evaluate whether the value of a property will be paid by the tenant over the lease term. Two of the more typical evaluators are a lease in which the tenant has the option to purchase the property at the end of the term for a nominal amount, or a lease in which the present value of rent payments is 90% of the value of the property. This current standard seems to fairly identify transactions that should be considered financing transactions and appear on a company’s balance sheet.
The new changes being contemplated with FASB 13 will place the Capital Lease label on nearly every transaction that is likely to be one year or longer. We say “likely” because even a lease of less than one year will be considered a Capital Lease if there is reasonable certainty that a tenant will renew or extend their lease (i.e. you can’t get around the reporting requirement by entering into a month-to-month transaction or annual lease with renewal options).
This reporting requirement for Capital Leases and the impact it has on the balance sheet typically make them less desirable than Operating Leases. For a company with a Capital Lease, in addition to showing a right-of-use asset, the balance sheet will disclose operating lease liabilities, which could greatly affect the appearance and leverage ratios of the balance sheet. As a result, investors and creditors might change their perception of the financial health of the company.
For many companies, however, the change may make purchasing real estate more attractive than leasing, since it will show up on their balance sheet either way. This could provide the additional incentive necessary for companies to take the leap and buy a building; a move that many tenants wouldn’t have considered in the past.
What is the status of the proposed change in accounting for leases and when might it be implemented?
FASB and the International Accounting Standards Board (IASB) met in mid-March and voted on several of the key components of the new accounting standard. There are a few remaining items to finalize (such as alternatives to reporting the Capital Lease), but the heart of the changes have been agreed upon. Once accepted, the expected effective date most likely won’t be until 2016 or 2017. However, prior comparative periods will need to be restated, so decisions being made today could have a significant impact on your company in the future.
What should a tenant do?
It is important for companies to understand how their balance sheets will look in the future once the new accounting standard takes effect. Tenants should discuss the coming changes with key audience members, including their real estate broker, CPA, attorney and investors, and plan wisely to mitigate the impacts to their bottom lines down the road.