CFO Studio Magazine, Fall 2011

New lease accounting standards promise to change the way CFOs report leases in financial statements

WHEN IT COMES to the way the U.S. Financial Accounting standards Board (FASB) works, there’s nothing as permanent as change. Indeed, the set of standards that guide accounting principles in this country are always evolving.

Currently up for discussion are new lease accounting standards being developed in a joint project between the FASB and the International Accounting Standards Board (IASB). Suggested changes that seek to more closely align U.S. reporting guidelines with the ones used outside this country were recently “re-exposed” to the financial community here, giving interested parties an almost unprecedented second opportunity to comment. These proposed changes, as written, completely overhaul the way leases are reported in financial statements. The new standard would effectively eliminate all “operating leases” and require them to be capitalized on a company’s balance sheet. It would also replace rent payment expense reporting with interest and depreciation expense reporting. Lessees (and possibly lessors) would have to change fundamentally the way they account for real estate and equipment leasing transactions, providing more extensive financial statement disclosures than ever before. For lessees, the new standards would also replace rent payment expense reporting with interest and amortization expense reporting.

Peter Bible, partner at EisnerAmper, LLP, says that the main thing CFOs must consider is how these changes will impact on lease vs. buy decisions going forward. “Historically, the lease vs. buy decision contained an element known as off-balance sheet financing, which operating lease treatment provided,” Bible explains. “Under the Proposed standard, this option would be removed as virtually all leases would be on balance sheet. Accordingly, CFOs need to focus on the economics of the alternatives.”

Face the Facts

Some industry projections estimate that if the standards are approved as is, over $1.3 trillion would be transferred to U.S. corporate balance sheets—with roughly 70 percent being real estate leases ($900 billion).

Considering that figure, “all other types of leases might be considered rather incidental,” says Greg Libertiny, CPA CFF ABV, relationship manager at Real estate strategies Corp. In addition to the significant lease accounting changes, at a glance, here are some of the significant changes outlined in the FASB exposure draft:

• Lessee recognizes “right-of-use” as an asset and the “obligation to pay rentals” as a liability.
• Right-of-use asset is initially recorded based on the present value of lease payments plus initial direct transaction costs, but less distinct operating expenses and property taxes.
• The accounting lease term will be the longest possible lease term that is more likely than not to occur.
• Contingent rentals (e.g., retail percentage rents) are required to be estimated and included in the initial measurement of the “right-of-use” asset and the “obligation to pay rentals.”
• Lease term and payments are reassessed each reporting period to include changes in projected renewals and contingency rents.

Experts point to a glaring issue that is lighting a fire under business strategists to change the way they consider real estate decisions going forward: the proposed new standards, at this point, call for “no grandfathering of existing leases; all leases would need to be reflected on the balance sheet upon adoption.”

As such, accountants like Ed O’Connell, CPA/CFF, CFE, partner at WithumSmith+Brown, and leader of the firm’s IFRS implementation, Convergence & Reporting team, suggest that while clients shouldn’t be making business decisions based on as-yet determined guidelines, they should be working hand-in-hand with all members of their advisory teams to put strategy in place.

“Depending on how complex your company is, once the rules are finalized, there may be a lot of accounting re-work to do depending on how many leases you have,” O’Connell says. “For this reason, leasing decisions today should be made considering what may change going forward.”

Impact on Strategy Going Forward

It’s quite clear that, regardless of exactly how the final standards look, the changes will affect overall real estate strategies and decision-making at large. Considering some of the potential changes—buy vs. lease decisions, length of lease options, impact of renewals and purchase options on lease obligations, and subleasing issues—companies need to start looking at their lease portfolios now for adequate lease information, technology capabilities, and resources to implement and monitor what will become the new standard.

“For the real estate industry, the impact of the proposed new lease accounting changes will impact both the balance sheet and tenant strategy and execution” Libertiny says. “For owners and operators, the big shift will be in what their tenants demand. Shorter-term leases may be in high demand along with an increased tenant appetite to forego renting in favor of buying.”

And, he adds, proper planning is critical because “the decisions you make today in real estate are going to impact everything for a very long time to come.”

Libertiny says it’s critical for CFOs to add “real estate professional” to their go-to team of advisors for all upcoming lease/purchase strategies. “It used to be ‘my lawyer, my accountant and my dentist.’ Now ‘real estate advisor’ should be part of your team— even before you need to think about real estate decisions. We can help to analyze a company’s capital and operating structures to determine whether leasing or buying makes sense going forward.” With pending IFRS guideline changes looming, experts suggest that CFOs consider that while leasing decisions won’t drive the business, they will play a bigger role than ever before in the future.

And, the fact is, for growing companies, the future is now. “You can’t afford to think about these things in two or three years,” says Libertiny. “This is a long-term planning issue that needs to be thought about now. If you are anticipating a real estate decision in the next three to five years, start the discussion with your advisors right now.”