By Bill Goade and Brant Bryan

Potential changes in lease accounting may have seismic consequences for the balance sheets of public companies:  Operating leases will likely be replaced by capital leases, shifting trillions of dollars to balance sheets of companies worldwide.  With all leases for commercial real estate being capitalized this way, the debt of most companies will increase dramatically. 

Historically, leases of real estate and equipment have been a critical source of financing used by almost all corporations.  However, the assets and liabilities arising from many of those contracts aren’t currently found on balance sheets.  Accordingly, in an attempt to standardize leases worldwide and promote transparency and understanding in financial reporting, the rules of the accounting game will likely be changing for tenants.

With so much at risk, tenants need to understand the proposed new accounting standards and begin to plan ahead now. Why is this so timely?  Because all leases that exist as of the official change in regulations will reflect the new standards and will not be grandfathered.

Why Are Proposed Changes Moving Forward? 

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) recently issued a joint Discussion Paper that details the changes introduced above. The impetus for the proposed changes dates back to the Enron scandal and other corporate bankruptcies, which raised concerns about off-balance accounting. 

Until this point, FASB and IASB have split leases into two categories:  capital (or finance) leases and operating leases.  With capital leases, assets and liabilities are recognized on the balance sheet. With operating leases, the lessee simply recognizes lease payments as an expense when they are incurred, or paid. Most companies prefer this kind of arrangement, since less debt is reported on the balance sheet.

However, the split into these two categories has led to concerns, including:

•           Undisclosed liabilities in the form of lease obligations.

•           Lack of transparency and comparability.

•           Opportunities to structure transactions to achieve a particular lease classification that may be difficult to understand. 

While the balance sheets of corporations are often adjusted to reflect a fair approximation of the debt the leases imply, critics claim that these adjustments are inconsistent and frequently understate the obligations of the leases.

What Are the Specifics of the New Proposal?

The proposed standards are based on the premise that all leases give rise to assets (the “right to use” the leased assets) and liabilities (future rental payments).

The proposed new principles for lessee accounting are:

•           There will be no distinction between operating leases and capital leases.

•           Leases will be capitalized based on the present value of the lease obligation.

•           The capitalized lease value will include the base rent as well as residual payments, obligated renewals, and contingent rents.

•           Rent expenses will cease to exist; the lease will be recognized as an asset financed by debt.

How Will this Affect Tenants?

Proposed changes are inevitable, and the repercussions will be considerable.  Virtually every organization will be affected, since almost all businesses lease assets, including real estate, office equipment, vehicles, etc. 

With these assets and liabilities added to balance sheets, companies will need to change the presentation and measures on their balance sheets.  Since most corporations use measurement metrics for a variety of purposes, it will be challenging for them to adapt to the new requirements.

Other challenges include:

•           Corporate balance sheets will inflate significantly. 

•           Many companies will appear more highly leveraged.

•           Expenses related to lease assets will no longer be straight lined; occupancy expense will be higher in the earlier years (as much as 15%) and lower in later years.

•           Corporations will face a heavy administrative burden since they will have to collect and input substantial data and perform complex calculations to determine the amount to be capitalized. 

What May Happen if Tenants Don’t Act?

Most companies have not developed a corporate strategy to address this issue or have been slow to start their transition plans.  Whatever their reasons, companies that don’t act do so at considerable risk.

The fact is, with no strategic response in place, many companies will face an acute short-term dilemma:  They may violate their debt covenants and be in loan default. 

When approached to modify the terms of debt, lenders may require costly incentives such as an escalated interest rate, debt pay-down, or an enhanced capital position.

What Should Tenants Do?

The proposed accounting changes are complicated, and no quick fix exists.  Still, companies need to understand the issues and address the options that best meet their needs.

The first step is to meet internally with accountants and consult with real estate advisors who specialize in capital markets.  These experts can review alternatives and help secure financing.

Specific considerations regarding the impending new standards include:

•           Buying vs. leasing.  Since your asset will be on the balance sheet anyway, it may be more advantageous to purchase your property or equipment.

•           Lease terms.  Leases of fewer than 10 years will result in higher rental rates but will reflect less debt on the balance sheet.  Mid-term leases (10 – 15 years) may result in a comparatively large debt burden.  Efficiently financed long-term leases (ideally 20-plus years) may be better financial alternatives due to lower obligations in later years. 

•           Creative financing and lease structures.  Given these pending accounting changes, there will likely be even more pressure on securing cost-efficient leases.  Many corporations have been considering options to free up capital so it can be reinvested in other areas of their business.  Corporate sale/leasebacks, in which one party sells an asset and then leases it back for a long term, have had a recent surge in popularity as a source of cash. 

•           New financial ratios (debt/equity and interest coverage ratios).  These ratios are key to securing capital, as they indicate the long-term solvency of a company.  Borrowers should begin discussions early with lenders regarding this proposed accounting change and their risk position.

•           Protect your interests.  Consider the advantages of working with a corporate real estate advisor that exclusively represents tenants, assuring that you have an advocate who will avoid conflicts of interest.

What’s Coming Next?

While the Discussion Paper provides a framework for the future, it acknowledges topics for which there is no present agreement between the FASB and IASB.  Among the issues to be decided are:  subleases; build-to-suits; short-term and small-sized leases; lease options such as purchase, renewal, expansion, and reduction; contingent rents; and measurement of leases already in place.

An exact date for the formal adoption of the new standards has not been determined.  The FASB and IASB boards are planning subsequent papers on new proposed standards, and these standards may not go into effect for another three to four years.  In the meantime, public comment on government proposals (now and in the future) is welcome.  To view the Discussion Paper and submit comments, visit www.fasb.org or www.iasb.org. 

While tenants can’t affect how quickly the wheels of public policy will turn, they can put their own initiatives in motion.  The process may be complicated, and it may incur some time and initial cost.  But the road will be much smoother if the journey starts now, and the long-term payoffs should prove to be significant. 

Think of it this way:  Companies may continue to fight for survival, but they don’t need to be buried prematurely by debt.