Financial rule makers aren’t usually known for dropping bombshells, but the new Financial Accounting Standards Board (FASB) standard issued in 2016 may have an explosive impact on how businesses operate. Blame it on the countdown Congress set off when it enacted the Sarbanes-Oxley Act in 2002 to ensure balance sheet transparency, particularly around commercial real estate leases.
The new FASB lease standard takes a dramatic change in approach; for leases beginning after Dec. 15, 2019 for public companies and Dec. 15, 2020 for privately held companies, every lease longer than 12 months will be recorded on the lessee’s balance sheet as both an asset and a liability. The new FASB lease standard will have deep effects on not only commercial real estate, but also on all leased assets. It could impact almost all businesses, notes PwC.
More than half of companies in a recent Deloitte poll will put more time and effort this year into converting to new financial reporting standards, noted Compliance Week, although only 14 percent were very or extremely prepared for the transition. Yet it’s essential that all chief financial officers (CFOs) include lease accounting in their financial strategy.
How The New FASB Standards Work
Lease accounting reforms start from a basic premise: Companies have to pay the rent, or bad things happen. On the face of it, that seems like a liability. But when you lock in lease payments, you’ve bought yourself a good deal of security. “A relocation often costs more and is more disruptive to an organization than a simple upgrade or modification of existing space,” notes Accounting Today magazine.
Yet despite these basic facts, generally accepted accounting principles have held that an operating lease on a building is neither an asset nor a liability. It’s just an expense reported off the balance sheet. Yet it does not always provide a faithful representation of leasing transactions, and a company’s liabilities.
In 2005, the the U.S. Securities and Exchange Commission asked the FASB to craft new rules after realizing that “approximately $1.25 trillion in non-cancelable future cash obligations committed under operating leases” were still being disclosed in financial statement notes rather than in the actual balance sheets. The FASB’s new standard on leases ends most distinctions between capital leases on equipment and operating leases such on commercial real estate.
How does that work? When you lease a computer for five years, you’re basically buying it. You can’t do much with a five-year-old computer--it runs slow; it doesn’t have the memory you need. You might give it to your kid for homework, but then she’ll complain her video games won’t work right unless you get whatever all her friends have. So a leased computer costs nearly as much as a new computer because there’s not a huge market for used computers.
What the new FASB lease changes will do is turn office buildings into computers. You’re essentially buying the right to use a space for as long as your lease runs, and at the end turning over a used space that may not be as attractive to prospective tenants who have a variety of choices. Nor may the used space be as valuable to the building owner.
These realties are reflected on the balance sheet, which recognizes the value of the building when the lease is signed, and a residual value when lessees hand back the keys. So the income statement depicts the lease transaction more like a purchase: The rent can be seen as the amortization of the asset’s value along with an effective interest rate for buying the rights to use the space.
Tenant representatives aren’t accountants, but we know the value of leases and where the market is moving. An experienced tenant representative should be able to offer strategic advice on how the FASB’s lease accounting changes will impact their clients.
5 Disruptive Consequences Of The New FASB Standards
Those impacts will be extensive. Bloomberg BNA points out that the balance sheets of many companies are expected to balloon under the FASB’s new least accounting rules. At Howard Ecker + Company, we agree. Here are five potential disruptions we see that extend far beyond the balance sheet:
1. Until lenders adjust their thinking and recognize the financial impact wrought by the new standard, financing will tighten once rent obligations are recognized as debts. Companies may fall out of compliance with their loan agreements, and may need to renegotiate their loans or boost their capital requirements. Higher debt ratios will make credit harder to get.
2. Companies must scrutinize all their leases to analyze their impact on lease accounting, maintains Deloitte. Companies will have to look carefully at what they classify—or do not classify—as leases and previously off-balance sheet items, such as some types of equipment, may have to be moved onto the balance sheet. Deloitte notes that some companies may need to keep multiple sets of books to satisfy different requirements and needs, and many firms simply aren’t equipped to handle the level of tracking these changes will require.
3. Tenants will have fewer reasons not to buy their buildings outright once the transaction is treated as another obligation on the balance sheet, points out the Deloitte consulting firm. Businesses may have to account for purchase options as if they’ll be executed. Technology companies that host servers and lease space for future expansion may need to write down its value right away.
4. Investors may think businesses are running less efficiently with these extra liabilities, and CFOs will want to make clear what kind of future cash outlays are involved in these leases to show that their business fundamentals haven’t changed.
5. Negotiating a commercial real estate lease will become much more complex and contentious, confirms National Real Estate Investor. Developers and Landlords still want the certainty of a long-term lease, but companies will get more of an edge from shorter commitments.
Things will get interesting when the accountants get to work. Brokers who represent tenants should be able to advise clients not only whether a lease is priced right, but also the real impact it will have on their underlying business. Forward-looking CFOs will want to become involved directly in commercial real estate decisions and need advice they can trust.