The Financial Accounting Standards Board, which sets American standards, has been working with the International Accounting Standards Board to merge its generally accepted accounting principles, or GAAP, with international standards. One major piece of the puzzle is the accounting for leases.
The two boards have come up with a new standard, which will be completed next year and enacted in 2013, that will require companies to book leases as assets and liabilities on their balance sheets. Currently, American and foreign companies list many leases as footnotes in their financial statements. As a result of the change, public companies will have to put some $1.3 trillion in leases on their balance sheets, according to estimates by the Securities and Exchange Commission. Because many private companies also follow GAAP accounting, the number could be closer to $2 trillion, experts said.
“It is going to get ugly,” said Mindy Berman, a managing director of corporate capital markets at the real estate services company Jones Lang LaSalle. “On the day the standard gets implemented, all these companies will suddenly have to record much higher rent, and they are going to have to record this as a significant liability on their balance sheet.”
There will be no grandfathering clause when the rule takes effect, so any active lease will have to be recorded on the balance sheet. Companies will record as a liability the cost of rent over the remaining term of the lease and record as an asset their right to use the space.
This could have several implications, including weakening companies in the eyes of investors and activating debt covenants with lenders. It could also affect credit ratings. While ratings agencies say they already take into consideration rent obligations, the new standard requires additional disclosures that could shed new light on lease terms.
The accounting change is meant to stop “significant off-balance-sheet activity for leases,” said Russell G. Golden, the technical director of FASB. The board expects to issue a new draft document outlining the changes this summer. This follows a months-long period in which nearly 300 companies sent letters commenting on the proposal.
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Among those most heavily affected by the changes will be companies that are already struggling under heavy debt loads, as well as large retailers that have hundreds, if not thousands, of leases. Commercial banks with multiple branches may also be severely hit in 2013, especially if that industry is still recovering from the recession.
“We are busy preparing clients to make them aware of the changes and help them analyze how it might impact them,” said Barry M. Gosin, chief executive at Newmark Knight Frank, the real estate services firm. “There are so many complicating factors that will make this an administrative nightmare.”
The new standard is expected to have ripple effects in the leasing market. One of the chief changes is to remove many of the differences in the way companies account for property that they own and property they lease. This may cause more companies to buy their offices and drive down demand for leased space, experts said.
There may also be an impetus to shrink the length of a lease. “If you have a 10-year lease, it will mean putting twice as much debt on the balance sheet as a five-year lease, so some companies may want to go short term,” said Dale F. Schlather, an executive vice president for the commercial real estate company Cushman & Wakefield and chairman of the New York chapter for the industry group CoreNet Global.
Further complicating matters is the accounting for lease renewals. Many companies sign leases with renewal terms, like a 10-year lease with an option to renew for another five years. Under the new rules, if it is likely that the company will execute the renewal option, they must account for the lease as if it were actually 15 years. Because this will mean adding more debt to the balance sheets, renewal options could become less popular.
In addition, some industries, including most retailers, sign leases with so-called contingent rents, which are based on a percentage of sales. Under the new standard, companies with these agreements will have to estimate their sales numbers over the entire term of the lease to book it on their balance sheet.
“Retailers are going nuts right now,” said Brant Bryan, a managing principal at Cresa Partners, a real estate advisory firm. “They have the daunting task of having to estimate their sales way into the future, and to make it worse, they will have to reassess these estimates over and over at every reporting period.”
Landlords will also see new accounting treatments. Mr. Golden of the standards board said that as the new rules were written now, landlords would record as a liability the obligation to provide space and record as an asset the rents they received. And while landlords currently book all of their revenue as rental income, under the new standard the rents will be recorded partly as interest income and partly as a reduction in the obligation to provide space.
But it isn’t all bad news. Under the new standards, companies that lease space are considered to be buying the right to use that space for a certain amount of time. So, not unlike a home buyer who begins with a large mortgage but then reduces it as the principal is paid down, companies will record their rent as a major liability at the start, but will eventually reduce this debt over the term of the lease.
While many companies say they support recording their leases on their balance sheets in the interest of transparency, what is controversial is how to enact this change. Having to estimate the likelihood of a renewal option or future sales, for example, “requires forecasting what you are going to pay rather than the legal obligation of what you will have to pay,” said John Hepp, a partner at the advisory firm Grant Thornton. “Accounting is supposed to be pragmatic, but now we are being asked to think more like economists. That is a whole different ballgame.”
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