Significant changes in lease accounting are on the horizon. Is your company ready?
|By: Diane Kern and Brandon Maves
||May 2011 |
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:
Educate yourself and your clients. Make sure everyone understands the implications of what the rule changes could do to their business. Keep abreast of ongoing developments surrounding the decision making process.
Evaluate your company’s resources. If necessary, call on industry experts who can assist.
Speak with your company’s real estate provider to learn what tools are available to test the financial reporting impact on your company’s portfolio. This can be done by running the numbers based on the rules we know today.
Reevaluate the effects of owning versus leasing space on the balance sheet.
Evaluate what these changes will do to significant contractual arrangements such as debt agreements, purchase agreements, employee compensation arrangements and acquisitions — anything that would be impacted by a change in the financial position of the company.
Look at your lease administration technology. How will you capture the additional data requirements that will be required to report, including the source of such data? Automate as much as you can!
Expand procedures, systems and tools to estimate the present value of future rent and contingent lease payments. What is your capital approval? What are your deal analysis tools? What are the policies and procedures for capturing that information and what are the changes in those policies?
As accounting rule makers continue to deliberate over the best possible approach, no one fully understands the extent to which new accounting changes will impact companies or what exactly the requirements will be. By being proactive and pursuing various initiatives in the here and now, your company will gain an edge and will be better positioned in the long run, well prepared to endure any shifts in weather, which are, in one shape or form, looming on the horizon.
Diane Kern is vice president of financial reporting for NorthMarq. As a CoreNet Global member who specializes in real estate accounting, Kern is closely monitoring how proposed accounting changes will affect the real estate industry. Brandon Maves is assurance partner for Minneapolis-based McGladrey & Pullen. His experience includes providing business assurance and advisory services to all segments of the real estate and construction industry.
This article first appeared in the May 2011 edition of CoreNet Leader. View a PDF of the article