The commercial real estate industry is abuzz with the proposed changes to lease accounting under generally accepted accounting principles (GAAP). On August 17, 2010, we moved one step closer to these changes with the joint release by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) of an Exposure Draft of such proposed changes.
Interested parties may comment on the proposed changes any time prior to December 15, 2010 and KBA intends to do so. The Boards intend to finalize these new standards sometime during 2011, with possible implementation in 2013. Whenever the actual start date, they will provide enough time to prepare for all the changes.
Why the Changes?
The Boards are trying to eliminate a “form over substance” distinction in GAAP accounting regarding typical, non-financing “operating” leases that has led to confusion and potential under-reporting in financial statements. The Boards consider all leases, including operating leases, to be financially equivalent to purchasing the right to use an asset and financing it.
For example, the Boards see little economic distinction between a company entering into a long-term lease for a piece of equipment versus purchasing and financing it. In both cases, the company is making periodic payments over an agreed time period for the right to use the equipment. This is most obvious in the case of financing or “capital” leases, which are leases with very obvious purchase characteristics (e.g., the aggregate of the lease payments is similar to the purchase price and there is a purchase option at the end for nominal value). Capital leases have long been treated as financed purchases under GAAP.
Real estate leases are no different than equipment leases and face the same form-over-substance issue. There is little economic difference between leasing a building for 30 years versus purchasing and financing it via a 30-year mortgage loan. Like the equipment lease, in both cases, the company is making periodic payments for the right to use the building over 30 years.
Despite these economic similarities, under current GAAP, operating leases and financed purchases are treated very differently in financial statements. Currently, lease payments made under operating leases (i.e., non-financing leases) are recorded as expenses on the income statement as incurred, and nothing is recorded on the balance sheet. In contrast, for actual financed purchases and capital (financing) leases, an asset and corresponding loan is recorded on the balance sheet and depreciation and interest are recorded as expenses on the income statement. The carrying value of the asset is reduced each year as depreciation is expensed, and the loan balance is reduced as lease payments are made.
These differing treatments have lead to a lack of comparability and undue complexity. In fact, many users of financial statements (lenders, investors, etc.) find themselves adjusting such statements to reflect the “true” assets and liabilities arising from operating leases. The Boards believe providing for uniform treatment for nearly all lease transactions will provide reliable information that is useful to present and potential investors and creditors and other financial statement users in making rational investment, credit and other decisions.
What Will Change
In simple terms, the proposals would treat all operating leases like financed purchases, with the asset being the “right to use” the underlying leased asset for the lease term, and the liability being the loan value to finance that asset. This is similar to the treatment of capital leases under current GAAP.
Thus, a 5-year lease for space in an office building would be treated as the purchase of the right to use the space for 5 years through a single up-front payment financed via a 5-year loan.
Life of the “Asset” and Length of the “Loan”
There is a wrinkle in the proposed changes, however. As proposed, the life used to establish the asset value and the length of the loan would not be the actual length of the lease, but rather the longest “likely” length of the term, taking into account the likelihood of exercising options to extend or terminate it. In other words, if a tenant has a 5-year lease with options to extend the lease for two additional 5-year terms, and the tenant believes it will most likely exercise the first option, then it must treat the asset life and loan period as being 10 years in length.
Furthermore, the proposal requires that the initially established asset values and loan amounts to be adjusted as and when the underlying facts or circumstances change. In other words, if the tenant in the foregoing example changes its opinion and now believes that it will most likely exercise both options, it must recalculate the asset value and loan amount on its balance sheet assuming the 15-years term.
KBA is concerned that this variability will lead to confusion, complexity and possible manipulation, and might expose corporate officers to criticism if estimates prove to be incorrect. Furthermore, those in corporate real estate negotiate options in their leases for flexibility, and disclosure of a company’s intention to exercise (or not exercise) an option has the potential to undermine its leverage in lease negotiations.
Treatment of Gross vs. Net Leases
The proposal will also require significant adjustments to the treatment of Gross and Modified Gross leases, which constitute the majority of commercial office leases in the US.
Commercial real estate leases contain two components: the use of the space, which the landlord grants in exchange for rent, and the servicing of the space (the operating, maintenance, real estate tax and insurance expenses), for which either the landlord or tenant is responsible depending on the lease. In pure Net leases, the tenant pays for the use of the space separately from the servicing costs, whereas in pure Gross leases, the rent covers both the use and servicing of the space.
Most commercial office leases are a hybrid of these two, and take the form of Modified Gross Leases. In Modified Gross Leases, the initial rent covers the initial cost of the services, and the tenant reimburses the landlord for increases in services over time. (For a more detailed discussion of Gross and Net leases, see KBA’s Lease Tip, “Demystifying the Difference between Net and Gross Leases.”)
Under the proposed changes to GAAP, it generally appears that the costs of servicing the space will continue to be expensed, whereas the cost of use of the space (i.e., the Net component) will have to be treated as a financed purchase. For Net leases this will be relatively easy, given that these costs are already segregated. However, for Gross and Modified Gross leases, a determination will have to be made to separate the two.
KBA intends to request clarification and guidance from the Boards regarding how to specifically handle the segregation of building service costs as part of gross and modified gross real estate leases.
Implications of the Changes
The proposed changes will eliminate off-balance sheet accounting, as they will require that the right-of-use assets associated with current operating leases be brought on to the balance sheet along with a corresponding liability. Therefore, companies currently with significant operating leases will see a “gross up” of their balance sheets.
A company’s Income Statement will change as well and reported net income could be depressed in the early years of a lease, as recognition will change. Straight-line rent expense will be replace with interest expense (for carrying the “loan” on the balance sheet) plus the amortization of the right-of-use asset. Because the interest expense will be higher in the earlier years (like a mortgage), the total annual expenses will be front-loaded.
Lease renewal and contingent rents will need to be continually reassessed and the related estimates modified as facts and circumstances change.
The proposed changes will require significant systems and process changes to be in place by their effective date (pre-existing leases are not expected to be grandfathered) and will also require continuous monitoring of all lease transactions.
To avoid some of the negative effects of the new proposals, leases could become significantly more complex as landlords’ and tenants’ objectives diverge. Tenants will be incentivized to sign relatively short-term leases; but this will be problematic for landlords that need to execute longer-term leases to satisfy lenders and investors.
KBA’s Thoughts
Does any of this make sense? From a pure financial reporting perspective, probably so. It puts all companies on an even playing field by establishing a consistent treatment for accounting and reporting their leasing transactions, regardless of what type of asset is being leased. So whether a company produces spare parts for the automobile industry and leases significant amounts of its machinery to do so, or a nationwide insurance company leases significant amounts of office space in major cities around the country to house its employees, parties interested in these companies’ financial position and condition will be able to use reliable comparative data in their decision making process.
For tenants, especially those that lease relatively small portions of large buildings in various scattered locations, all this may seem antithetical to why they chose to lease their space in the first place. If a company needs a limited presence in several locations, purchasing its real estate needs and operating each site is probably too costly. Leasing space which is operated by the owner is much more cost-effective, as the company is only paying for what it uses and only for the time it uses it. The company is not “buying” its space; in fact, the lease contract will specifically say that no ownership right is being transferred. So why will an asset be shown on its balance sheet? Also, the company is not borrowing money to make its monthly rent payments; those funds come from normal operating revenues. So why must it establish an artificial “loan” and calculate annual interest expense?
The answer to those questions, simply put, is that the Boards believe the changes are necessary to properly recognize the fact that lease contracts represent long-term financial commitments that provide lessees with certain use rights and establish legal liabilities for future payments associated with those use rights. If a lessee could, at any time, simply walk away from its rental obligations without legal consequences (i.e., no long-term commitments are established), perhaps the foregoing changes would not be necessary. However, we know that this is not the case, and so it is the accounting profession’s responsibility to make sure that those financial commitments are properly and consistently reflected in companies financial statements.
How KBA Can Help
If enacted (which, as of this date, now appears likely), the new accounting rules will require significant analysis and complex calculations to properly report each lease transaction. This will include:
With over 25 years experience successfully analyzing and auditing all types of commercial real estate leases, KBA is in a unique position to support lessees’ efforts to comply with the new accounting rules. If you need advice or assistance with the various assumptions and calculations necessary to convert your company’s current operating leases to the new accounting model recognizing a right-of-use asset and a liability to make rental payments, please contact us.
This is the clearest explanation I have seen about this issue. Well done! My understanding is that the international community, particularly the EU, have already been using these GAAP standards and this brings the US into the fold. Excellent explanation!
[...] Lease Accounting Changes under GAAP and How It Affects Commercial Real Estate Posted on September 16, 2010 by miamiofficenotes Click on the link below and read the best explanation I have seen on the proposed changes to GAAP and how it will affect companies. I am not an accountant and have been plodding through a number of white papers to understand this issue. KBA Lease Services breaks down the issue in a concise, clear manner. I strongly urge business owners both large and small to take a moment to read this article. [...]
Won’t shorter lease terms negatively impact prpoerty values?
Great piece on the impact of the new accounting rules. I’ve read several “white papers” on the subject and your article is the best written one I’ve read yet. Congratulations and thanks for the clear, concise explanation and context.
Great analysis and timely. But this not only about GAAP it’s about IFRS or International Financial Reporting Standards.
What is disingenuous and intellectual dishonest about all of this is that the US accounting community and in particular the large players in accounting and CRE have been downplaying IFRS as something that will take years to happen while those of us who do international work recognized that it was going to come and the first hit would be on leases.
Now like a thief in the night, this shows up and under the cover of a change in GAAP and consistently no mention of IFRS. But this is it, and you are reporting – First Blood
We do not live in a cocoon and everything is no longer invented in America. These changes are huge and will alter the balance sheet of thousands of companies overnight and fundamentally affect financial forecasts and projected ratios of real estate ventures on the drawing board and in process, the resultant impact on credit decisions will also be a major challenge.
KBA is on the money with this and should be engaged be every sane business whose auditors are in denial but will show up one morning to tell a previously sound client that they are no longer viable with excuses about congress, quality control and the UN while not admitting they were asleep at the wheel.
Great work and a warning !
[...] This post was mentioned on Twitter by Barbi Reuter, FHO Partners, Charlie Foxworth, Christopher Werely, KBA Lease Services and others. KBA Lease Services said: The Impact on Corporate Real Estate of Lease Accounting Changes under GAAP http://bit.ly/cv0zqM #CRE #CommercialRealEstate [...]
I believe shorter lease terms will impact a landlords ability to; (a) finance the acquisition of a building, and; (b) refinance an existing loan secured by a building. Lenders look for long term leases, regardless of any options (option is tenant’s, not landlords), and quality of tenant when considering the financing of a tenanted property. Shorter terms leases mean less “certainty” of tenancy and, accordingly, more risk.
More risk may result in an increase in a lenders LTV requirement (potential increase in down-payment), interest rate and/or points (prepaid interest) which will materially affect a buyer’s return on cash, thus reducing the price a potential buyer will be willing to pay for a property. A lender’s requirement of, say, a personal guarantee from a borrower will result in less buyers being willing to purchase and this will affect marketability and, ultimately, price.
[...] has received numerous responses to our latest Lease Tip, The Impact on Corporate Real Estate of Lease Accounting Changes under GAAP. We are preparing to provide comments to the FASB/IASB exposure draft regarding the following [...]
[...] a follow-up to our earlier Lease Tip, The Impact on Corporate Real Estate of Lease Accounting Changes under GAAP, we have compiled a list of the most instructive resources covering the effects of the proposed [...]
[...] Lease Accounting Changes under GAAP and How It Affects Commercial Real Estate Posted on September 16, 2010 by miamiofficenotes Click on the link below and read the best explanation I have seen on the proposed changes to GAAP and how it will affect companies. I am not an accountant and have been plodding through a number of white papers to understand this issue. KBA Lease Services breaks down the issue in a concise, clear manner. I strongly urge business owners both large and small to take a moment to read this article. [...]
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Another stupid idea brought to you because:
1) These bureaucrats have nothing better to do with their time
2) They are overly concerned with what a tiny handful of huge companies are doing.
Well guess what, those huge firms have a millions options for changing the way things appear on their financials. Meanwhile, they are creating additional compliance costs for the other 98% of companies who are too small to research every friggin FASB pronouncement so they will have to pony up even more cash to audit firms for the “correct accounting” procedure.
Thanks a lot.