New Lease Accounting Rules Suggest a New Look at Leasing

Tom Muller

“One long-term trend in US real estate is the divestiture of real estate owned by non-real estate companies. While there are many advantages to owning—and therefore controlling—your own real estate, non-real estate businesses, particularly publicly held companies, must take into account the drag of those real estate assets on their financial reports, particularly on their return on assets.” Those thoughts are according to Tom Muller , co-chair of the land use and real estate group at Manatt, Phelps & Phillips LLP in this exclusive column. According to Muller, with increasingly rapid changes in the business environment, outsourcing real estate to real estate companies has also given non-real estate companies greater flexibility in quickly expanding and contracting their use of real estate as conditions change. The views expressed in the below column are the author’s own. In February of this year, though, the Financial Accounting Standards Board and its international counterpart issued a new accounting standards update for leases that may cause some companies to revisit the own vs. lease question.  The new rules, effective for public companies with fiscal years starting after December 15, 2018, and for private companies a year later, significantly change how tenants account for leases on their balance sheets. The new rules now require companies to capitalize most leases on their balance sheet as both an asset and a liability. But the differing methods of calculating the asset value vs. the amount of the liability may lead to some unwelcome impacts on the company’s balance sheet. Not only do the new rules reduce tenants’ ability to structure leases to achieve desired accounting outcomes, they also tighten up existing accounting rules determining whether a sale-leaseback will be treated as a sale-leaseback or a financing transaction. Now is the time for real estate and finance executives in non-real estate companies to review their lease portfolios and leases under negotiation to evaluate the long term impact on the company’s balance sheet, and, where possible, consider renegotiating and restructuring problematic leases before the new standards become effective. Among the provisions to watch for in particular are renewal options that are so favorable to the tenant that the new accounting standards will view them as exercised, which can significantly increase the liabilities assigned to the lease without an equivalent increase in asset value.  Similarly, free rent, tenant improvement allowances and other incentives can skew the balance between the asset value and accounting liabilities assigned to the lease. One certain impact of the new standards will be a dramatic increase in the amount of data collection, judgment, senior management time and expense devoted to a company’s leases.  The new rules are deliberately open-ended in some respects, calling for fine judgments as to the many factors that go into categorizing leases under the new rules. Landlords, too, will need to think creatively about ways to meet their tenants’ goals in light of the new rules, probably including restructuring incentives and shortening lease terms. In light of the new rules, companies—especially those with hundreds of leases—may want to think again whether the advantages to leasing continue to outweigh the disadvantages.