The fundamental change under FAS Topic 840 is that all off-balance sheet transactions regarding operating leases (which include most real estate leases) is being eliminated. Currently, companies don’t show operating leases on their financial statements, except in footnotes. Yet, these transactions do represent significant financial obligations, especially when a company has a significant number of them.
Leases will appear on company (lessee) financial statements as though the company had purchased and then financed the leased asset (the equipment, in the case of equipment leases, or the block of space, in the case of real estate leases). This asset will appear on the balance sheet as a “right of use asset” with a corresponding liability for the rent payments. The initial amount recorded for the asset will be the net present value of the rent—including any scheduled rent increases as well as broker commissions—calculated at the rate it would cost the company to borrow money. The liability is recorded the same way; however, any commissions or other initial direct costs are excluded. As rent payments are made, they are recorded as payments of interest and principal, reducing the value of the liability to zero by the end of the lease term. The asset will be separately amortized, typically on a straight-line basis.
For landlords (and for tenants who are subleasing space to others), the balance sheet will show a “performance obligation” liability to provide the equipment or block of space and an “asset for the rent payments receivable.” Both would be calculated in a manner similar to the lessee model just discussed. Interestingly enough, because the interest factor used to calculate the NPV of the asset and liability is based on each individual company’s borrowing cost, the corresponding asset and liability values could be slightly different for the landlord and the tenant on either side of the same transaction.
There is a lot of the debate on two points— operating expenses and lease options. The right of use asset is only supposed to cover the pure use of the asset, not the costs to service it. In commercial real estate leases, it will be necessary to separate out service costs like CAM changes, taxes, and insurance from the right to use the space. Stripping out these costs will be easy with a pure triple-net lease since the tenant pays all these costs separately. It’s more muddled with a modified gross lease since the landlord pays these costs for the first, or base, year of the lease. Unless FASB clarifies how to define service charges, you will probably see more net leases. That may actually benefit landlords, since more of the risk for higher costs in the base year is shifted to the tenant.
Under the current proposal, tenants would have to consider how likely they are to exercise lease options from the first day they sign a lease. If they are “more likely than not” to extend, they have to include the option term and the option rent in their calculations. Similarly, contingent costs such as percentage rentsTo make things even more complicated, t and fees to exercise options must be evaluated and incorporated into the analysis. These issues can be very subjective, which seems to undermine the purpose of the rule changes.
To make things even more complicated, the tenant also has to reevaluate these variables every reporting period. Also, being required to publically disclose renewal intentions puts companies at a disadvantage when they try to negotiate a lease extension.
It seems likely that the proposal will be enacted in 2011 and go into effect a year or more later. There will be no grandfathering; all existing leases will need to be reclassified. For now, both landlords and tenants need to start considering these changes in their current lease negotiations and need to be sure that all their existing leases (both equipment and real estate) are organized and properly documented so that they can be analyzed when the rules go into effect.
For additional resources on this topic, please see KBA’s Blog and Additional Resource Index.