Significant changes in lease accounting are on the horizon. Is your company ready?

The possibility of dramatic changes to lease accounting rules is causing quite a stir in the commercial real estate world, leading many companies to reconsider how they manage their assets.

The rules, proposed by the U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), would significantly change how leases are reported on financial statements, requiring all leases of real estate and equipment with terms greater than 12 months to be capitalized on a company’s balance sheet. Under the proposed rules, there is no grandfathering clause, meaning this would hold true for both new and existing leases.

With real estate consistently reigning as a “top three” expense on the balance sheets of most companies, such changes, if accepted and enacted, could dramatically impact a company’s overall real estate strategy, and ultimately, its bottom line. 

Currently, most leasing is simply treated an expense. Many businesses lease their space or equipment under “operating leases,” which allow for only the current year’s expenses to be recorded on the income statement with no impact to the balance sheet. The proposed rules would largely eliminate this type of accounting, replacing the current straight-line rent expense reporting with balance sheet reporting.

The rule changes are being encouraged as part of an effort to see each of a company’s obligations on a single balance sheet. If the changes are accepted, a company’s financial statement will contain everything it owes to its various creditors, including any creditors of leased property.

Given the pending status of the changes, it is unclear how companies will respond to how their property is leased. Some may favor shorter-term leases while others may choose to simply own their property altogether. If the property needs to be listed on the balance sheet either way, certain businesses may decide that it makes more sense to have a hard asset on their books rather than a soft one.

Among those most affected by the change would be retailers with numerous leased spaces. Many retailers sign leases with “contingent rents,” which are based on a percentage of sales. Under the new proposal, retailers with these types of leases would be required to estimate the contingent rent based on their expected sales over the entire term of the lease in order to put it on their balance sheets. This will undoubtedly pose significant challenges.

The proposal is still under review, as rule makers are now in the process of deliberating over comments they have received from various constituencies. There is a strong indication that the final rule from the boards will come in 2011 with adoption expected in 2013 or 2014.

Although it is impossible to predict what the ultimate standard will contain, the general feeling is that the new requirements will still depart from the current rules and will likely require significant resources to adopt. Companies should begin contemplating how such changes could impact their business, including financial statements, contractual relationships, financial covenants or their future decision-making processes.

Taking decisive steps in the intermediate will ensure that a company has enough time to implement all the necessary changes to their business processes, leasing policies, staffing levels and system capabilities.

Steps to prepare for lease accounting changes:

This article first appeared in the May 2011 edition of CoreNet Leader. View a PDF of the article