ATLANTA—In May 2013, the Financial Accounting Standards Board and the International Accounting Standards Board issued a revised exposure draft of their proposed changes to lease accounting rules. The revised draft came nearly three years after the original exposure draft, which conveys some sense of how long the two groups have been working on this project.
With such a protracted time frame, it may have seemed to many that the brave new world of lease accounting would never actually become reality. Yet as FASB and IASB edge closer to completing the new accounting regimen, Sean Moynihan, Gary Hubbard and other experts at Avison Young warn that the effective date of the new rules—2018—is closer than it seems, and the time to begin preparing is now.
“While the exact details of the proposed lease accounting standard will be subject to ongoing refinement, the broad requirements have become more defined—and there are many things that real estate lessees and lessors can, and should, be doing today with respect to their lease structures, business operations and financial reporting processes,” says Hubbard, AY's Chicago-based CFO. “By planning and starting early, companies can more effectively manage the process and minimize the surprises.” More to the point, Atlanta-based AY principal Sean Moynihan warns that “many companies will be blindsided in '18 if they don't prepare now.”
That potential blindsiding will mainly befall tenants; the FASB and IASB boards generally will follow the current model for lessors. Among other changes, leases of longer than 12 months will be capitalized, meaning that most real estate leases will move onto the balance sheets of the companies occupying the space. “Even a renewal option in a single lease contract could reduce shareholder equity by millions of dollars,” Moynihan points out.
No exceptions will be made for existing leases; the new FASB/IASB regime will not include a grandfather clause. Accordingly, AY says, every lease in a company's real estate portfolio could negatively impact its financial statements. Public companies, which must include comparative financial data in their financial statements, will effectively be required to transition to the new rules in advance of '18 to stay compliant with SEC regulations.
“One of the key challenges for real estate decision-makers is that using discounted cash flow to analyze lease deals, which is the common practice now, doesn't work under the new rules,” says Moynihan. “Executives should take a much more active role in the negotiation process and engage with their colleagues in finance at a deeper level to ensure the impact is fully understood before signing a lease.”
Such cooperation between corporate real estate and corporate finance is one of the hallmarks of AY's recommendations for making the transition to the new lease accounting standards. “Often, those in finance are not familiar with how real estate leases are structured, and real estate professionals do not appreciate the accounting impact of leases,” according to AY.
The services firm recommends conducting a strategic evaluation of the existing lease portfolio, starting with the largest leases, and assess how they will be accounted for under the new rules. That includes assessing the impact on EBITDA and other key financial ratios and evaluating the potential impact on loan covenants.
Tenants should consider renegotiating leases now, even if they're not up for renewal, in order to mitigate some of the less favorable impacts that would otherwise occur. As for new leases, AY recommends reducing the spread between a lease's liability and the corresponding right-of-use asset. The more these two items are out of balance, the greater their potential negative impact.
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Paul Bubny
Paul Bubny is managing editor of Real Estate Forum and GlobeSt.com. He has been reporting on business since 1988 and on commercial real estate since 2007. He is based at ALM Real Estate Media Group's offices in New York City.
