Introduction:

The Financial Accounting Standards Board (FASB) on August 17, 2010 published its “exposure draft” that requires companies to record nearly all leases on their balance sheets as a “right-of-use” asset and a “right-of-use” asset. future lease – liability” corresponding. . What does this mean for your business in simple terms? This proposal, in essence, eliminates operating leases; All leases (unless they are immaterial) would be capitalized using the present value of the minimum lease payments. Therefore, companies that in the past had off-balance sheet lease obligations are now required to record these obligations on their balance sheet.

A key point to consider regarding the proposed lease accounting changes is that, in all likelihood, existing operating leases, signed prior to the implementation of the new rules, will require reclassification as capital leases that must be accounted for on the balance sheet. This means that real estate professionals must immediately consider the effect existing and planned leases will have on financial statements once the proposed rules are implemented. Since operating lease obligations can represent a liability greater than all balance sheet assets combined, lease reclassification can significantly alter companies’ balance sheets.

The impact of recording these lease obligations on the balance sheet can have multiple impacts, such as: businesses needing to alert their lenders as they will now default on their loan agreements, negotiating new loan agreements with lenders due to the upgrade financial statements, the ratios used to assess a company’s credit potential will be adversely affected, and restatement of a lessee’s financial statement once the change takes effect may result in a lower principal balance and changes to various ratios accountants

The conceptual basis for lease accounting would change from determining when “substantially all the benefits and risks of ownership” have been transferred, to recognizing the “right of use” as an asset and allocating the assets (and liabilities) between the lessee and the landlord.

As part of the FASB’s announcement, the Board stated that, in its opinion, “current accounting in this area does not clearly reflect the resources and liabilities arising from lease transactions.” This suggests that the bottom line will likely require more leasing activity to show up on the balance sheet than it currently is. In other words, it is likely that many, perhaps virtually all, leases that are now considered operating leases will be considered capital under the new standards. Therefore, many companies with large operating lease portfolios are likely to see a major change in their corporate financial statements.

Part of the purpose of 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 substantial differences in their treatment of leases; particularly notable is that the “bright line” tests of FAS 13 (if the lease term is 75% or more of the economic life, and if the present value of the rentals is 90% or more of the fair value) do not are used by the IASB, which prefers a “facts and circumstances” approach that involves more judgment calls. Both, however, have the concept of capital (or financial) and operating leases, however the dividing line between such leases is drawn.

The FASB will accept public comments on this proposed change until December 15, 2010. If the FASB makes a final decision in 2011 regarding this proposed change in lease accounting, the new rules will take effect in 2013.

In addition, Securities and Exchange Commission staff reported in a report ordered by Sarbanes-Oxley, that the amount of operating leases held off the balance sheet is estimated at $1.25 trillion that would be transferred to corporate balance sheets if this accounting proposal the change is adopted.

Commercial Real Estate:

The impact on the Commercial Real Estate market would be substantial and will have a significant impact on commercial landlords and renters. David Nebiker, Managing Partner of ProTenant (a commercial real estate firm that focuses on helping Denver and regional companies strategize, develop and implement comprehensive long-term facility solutions) added, “This proposed change affects not only tenants and landlords, but intermediaries, as it increases the complexity of leases and provides a strong impetus for tenants to execute short-term leases.”

Short-term leases create financial problems for homeowners, as lenders and investors prefer longer-term leases to secure their investment. Therefore, homeowners should secure financing to purchase or refinance prior to the implementation of this regulation, as financing will become considerably more difficult in the future.

This accounting change will increase the administrative burden on businesses and will effectively eliminate the lease premium for single-tenant buildings. John McAslan, Associate at ProTenant, added: “The impact of this proposed change will have a significant impact on leasing behavior. Landlords of single-tenant buildings will wonder why not just own the building, if I have to register it.” in my financial statements anyway.”

Under the proposed rules, lessees would have to capitalize the present value of virtually all “probable” lease obligations on corporate balance sheets. The FASB views leasing essentially as a form of financing in which the lessor allows the lessee to use a capital asset, in exchange for a lease payment that includes principal and interest, similar to a mortgage.

David Nebiker said, “Regulators have missed the point of why most businesses lease and that’s for flexibility as their workforces expand and contract, as location needs change, and businesses they prefer to invest their cash in producing income growth, rather than owning real estate.”

The proposed accounting changes will also affect owners, especially companies that are publicly traded or hold public debt with audited financial statements. Shopping center owners and trusts will be required to conduct analysis for each tenant located in their buildings or shopping centers, looking at terms of occupancy and contingent lease fees.

Proactive landlords, tenants, and brokers should familiarize themselves with the proposed standards that could go into effect in 2013 and begin negotiating leases accordingly.

Conclusion:

The end result of this proposed lease accounting change is an increased compliance burden for the lessee, as all leases will have a tax-deferred component, will be accounted for on the balance sheet, will require periodic reassessment, and may require more detailed disclosure. of the financial statements.

Therefore, lessors must know how to structure and sell transactions that will be desirable to lessees in the future. Many lessees will find that the new rules remove the off-balance sheet benefits that FASB 13 provided them in the past and will find leasing a less beneficial option. They may also view the new standards as more cumbersome and complicated to account for and disclose. Ultimately, it will become a challenge for every commercial real estate landlord and broker to find a new approach to marketing commercial real estate leases that makes them more attractive than ownership.

However, this proposed accounting change to FAS 13 could potentially spur a lackluster commercial real estate market in 2011 and 2012, as companies chose to purchase properties rather than deal with lease administration issues in 2013 and beyond.

In conclusion, it is recommended that landlords and tenants begin preparing for this change by reviewing their lease agreements with their commercial real estate broker and discussing the financial ramifications with their CFO, outside accountant, and tax accountant to avoid potential financial surprises if/when accounting change. they are adopted.

Both David Nebiker and John McAslan of ProTenant indicated that their entire corporate team is continually educating themselves and proactively advising their clients on these potential changes.

Annex – Definition of Capital Lease and Operating Lease:

The basic concept of lease accounting is that some leases are simply rentals, while others are effectively purchases. For example, if a company leases office space for a year, the space is worth almost as much at the end of the year as when the lease began; the company is simply using it for a short period of time, and this is an example of an operating lease.

However, if a business leases a computer for five years, and at the end of the lease, the computer is almost worthless. The lessor (the company that receives the lease payments) anticipates this and charges the lessee (the company that uses the asset) a lease payment that will recover all the costs of the lease, including 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 in the lessee’s financial statements. Essentially, capital lease payments are considered repayments of a loan; depreciation and interest expense, rather than lease expense, are recorded in the income statement.

Operating leases do not normally affect a company’s balance sheet. There is, however, an exception. If a lease has scheduled changes in the lease payment (for example, a planned increase due to inflation or a vacation in the lease during the first six months), the rental expense should be recognized in equal parts over the life of the lease. The difference between the recognized lease expense and the lease actually paid is considered a deferred liability (for the lessee, if the leases are increasing) or an asset (if it is decreasing).

Whether capital or operating, future minimum lease commitments must also be disclosed as a footnote to the financial statements. The lease commitment must be broken down by year for the first five years and then all remaining rents are combined.

A lease is capital if any of the following four tests is met:

1) The lease transfers ownership to the lessee at the end of the lease term;

2) The lessee has the option to purchase the asset at a bargain price at the end of the lease term

3) The lease term 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 market 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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