Mortgage Interest Rates Forecast - Fasb Proposed Lease Accounting Changes - Impacts on commercial Real Estate
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The Financial Accounting Standards Board (Fasb) on August, 17, 2010 released their "exposure draft" requiring associates to report nearly all leases on their balance sheets as a "right to use" asset, and a corresponding "future lease payment - liability". What does this mean to your enterprise in layman terms? This proposal in essence does away with operating leases; all leases (unless immaterial) would be capitalized using the present value of the minimum lease payments. Therefore, businesses who in the past had off-balance sheet lease obligations, must now report these obligations on their balance sheet.
A key point to reconsider with regards to the proposed lease accounting changes is that, in all likelihood, existing operating leases, signed prior to the implementation of the new rules, will wish reclassification as capital leases that must be accounted for on the balance sheet. This means that real estate professionals must immediately reconsider the ensue that existing and planned leases will have on financial statements once the proposed rules are implemented. Since operating lease obligations can recite a larger liability than all balance sheet assets combined, lease reclassification can significantly alter the businesses balance sheet.
The impact of recording these lease obligations on the balance sheet can have many impacts, such as: businesses needing to alert their lenders as they will now be non-compliant with their loan covenants, negotiating new loan covenants with the lenders due to the restated financial statements, ratios used to value a businesses inherent of reputation will be adversely impacted and the restatement of a lessee's financial statement once the convert takes ensue may ensue in a lower equity balance, and changes to various accounting ratios
The conceptual basis for lease accounting would convert from determining when "substantially all the benefits and risks of ownership" have been transferred, to recognizing "right to use" as an asset and apportioning assets (and obligations) between the lessee and the lessor.
As part of Fasb's announcement, the Board stated that in their view "the current accounting in this area does not clearly portray the resources and obligations arising from lease transactions." This suggests that the final ensue will likely wish more leasing action to be reflected on the balance sheet than is currently the case. In other words, many, possibly virtually all, leases now considered operating are likely to be considered capital under the new standards. Thus, many associates with large operating lease portfolios are likely to see a material convert on their corporate financial statements.
Part of the purpose for this 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 have astronomical differences in their medicine of leases; particularly preeminent is that the "bright line" tests of Fas 13 (whether the lease term is 75% or more of the economic life, and either the present value of the rents is 90% or more of the fair value) are not used by the Iasb, which prefers a "facts and circumstances" advent that entails more judgment calls. Both, however, have the opinion of capital (or finance) and operating leases, however the dividing line is drawn between such leases.
The Fasb will accept communal comments on this proposed convert straight through December 15, 2010. If Fasb makes a final decision in 2011 with regard to this proposed convert to lease accounting, the new rules will go into ensue in 2013.
Additionally, the staff of the Securities and change Commission reported in a report mandated under Sarbanes-Oxley, that the number of operating leases which are kept off the balance sheet is estimated at .25 trillion that would be transferred to corporate balance sheets if this proposed accounting convert is adopted.
Commercial Real Estate:
The impact on the market Real Estate store would be astronomical and will have a needful impact on market tenants and landlords. David Nebiker, Managing Partner of ProTenant (a market real estate firm that focuses on assisting Denver and regional associates to strategize, develop, and implement long-term, broad facility solutions) added "this proposed convert not only effects the tenants and landlords, but brokers as it increases the complexity of lease agreements and provides a strong impetus for tenants to execute shorter term leases".
The shorter term leases create financing issues for property owners as lenders and investors prefer longer term leases to get their investment. Therefore, landlords should get financing for purchase or refinance prior to the implementation of this regulation, as financing will be considerably more difficult the future.
This accounting convert will growth the executive burden on associates and the leasing superior for particular tenant structure will effectively be eliminated. John McAslan an join together at ProTenant added "the impact of this proposed convert will have a needful impact on leasing behavior. Lessors of particular tenant structure will ask themselves why not just own the building, if I have to report it on my financial statements anyway?"
Under the proposed rules, tenants would have to capitalize the present value of virtually all "likely" lease obligations on the corporate balance sheets. Fasb views leasing essentially as a form of financing in which the landlord is letting a tenant use a capital asset, in change for a lease payment that includes the needful and interest, similar to a mortgage.
David Nebiker said "the regulators have missed the point of why most businesses lease and that is for flexibility as their workforce expands and contracts, as location needs change, and businesses would rather spend their cash in producing earnings growth, rather than owning real estate."
The proposed accounting changes will also impact landlords, especially enterprise that are publicly traded or have communal debt with audited financial statements. Mall owners and trusts will required to achieve analysis for each tenant located in their structure or malls, analyzing the terms of occupancy and contingent lease rates.
Proactive landlords, tenants and brokers need to warn themselves with the proposed standards that could take ensue in 2013 and begin to negotiate leases accordingly.
Conclusion:
The end ensue of this proposed lease accounting convert is a greater yielding burden for the lessee as all leases will have a deferred tax component, will be carried on the balance sheet, will wish periodic reassessment and may wish more detailed financial statement disclosure.
Therefore, lessors need to know how to structure and sell transactions that will be desirable to lessees in the future. Many lessees will realize that the new rules take away the off balance sheet benefits Fasb 13 afforded them in the past, and will conclude leasing to be a less useful option. They may also see the new standards as being more cumbersome and involved to list for and disclose. Finally, it will come to be a challenge for every lessor and market real estate broker to find a new advent for marketing market real estate leases that make them more spicy than owning.
However, this proposed accounting convert to Fas 13 could potentially stimulate a lack luster market real estate store in 2011 and 2012 as businesses decided to purchase property rather than deal with the executive issues of leasing in 2013 and beyond.
In conclusion, it is recommended that landlords and tenants begin establishment for this convert by reviewing their leases with their market real estate broker and discussing the financial ramifications with their Cfo, outside accountant and tax accountant to avoid inherent financial surprises if/when the accounting changes are adopted.
Both David Nebiker and John McAslan of ProTenant indicated their entire corporate team are continually educating themselves and advising their clients about these inherent changes on a pro-active basis.
Addendum - Definition of Capital and Operating Leases:
The basic opinion of lease accounting is that some leases are merely rentals, whereas others are effectively purchases. As an example, if a enterprise rents office space for a year, the space is worth nearly as much at the end of the year as when the lease started; the enterprise is naturally using it for a short duration of time, and this is an example of an operating lease.
However, if a enterprise leases a computer for five years, and at the end of the lease the computer is nearly worthless. The lessor (the enterprise who receives the lease payments) anticipates this, and charges the lessee (the enterprise who uses the asset) a lease payment that will recover all of the lease's costs, along with a profit. This transaction is called a capital lease, however it is essentially a purchase with a loan, as such an asset and liability must be recorded on the lessee's financial statements. Essentially, the capital lease payments are considered repayments of a loan; depreciation and interest expense, rather than lease expense, are then recorded on the earnings statement.
Operating leases do not ordinarily sway a company's balance sheet. There is, however, one exception. If a lease has scheduled changes in the lease payment (for instance, a planned growth for inflation, or a lease holiday for the first six months), the rent cost is to be recognized on an equal basis over the life of the lease. The discrepancy between the lease cost recognized and the lease truly paid is considered a deferred liability (for the lessee, if the leases are increasing) or asset (if decreasing).
Whether capital or operating, the future minimum lease commitments must also be disclosed as a footnote in the financial statements. The lease commitment must be broken out by year for the first five years, and then all remaining rents are combined.
A lease is capital if any one of the following four tests is met:
1) The lease conveys proprietary to the lessee at the end of the lease term;
2) The lessee has an selection to purchase the asset at a agreement price at the end of the lease term
3) The term of the lease is 75% or more of the economic life of the asset.
4) The present value of the rents, using the lessee's incremental borrowing rate, is 90% or more of the fair store value of the asset.
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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