CCIM Magazine Covers New Lease Accounting Rules in Current Issue

Counting Leases Before They Hatch

A proposed accounting change will dramatically affect how landlords and tenants treat leases.

by Tom Muller

The accounting profession is currently evaluating a proposed new standard that promises to fundamentally change the ways landlords and tenants account for — and negotiate — leases.Under review is a proposed rewriting of the Financial Standards Accounting Board’s Accounting Standards Codification Topic 840, which before 2009 was known as FAS 13. This topic, "Accounting for Leases," is one of many standards that together comprise generally accepted accounting principles, or GAAP, in the United States.

The draft standard has drawn much heated debate for its potential to fundamentally change the leasing market, likely shortening lease terms and dramatically reducing the apparent value of properties with traditionally long lease terms, such as office buildings.

What Is Being Proposed?

According to FASB, the proposed new rule responds to dissatisfaction with the way that operating leases are disclosed on companies’ financial statements. Current financial standards draw a distinction between operating leases — the standard landlord/tenant relationship — and capital leases, typically used as an alternative form of financing. Current rules effectively ignore the documented structure of capital leases, instead treating the leased property as if it were owned by the tenant and financed by the landlord.

FASB notes that many companies have carefully structured their leases in view of the current rules to achieve characterization as either operating leases or capital leases, resulting in strikingly different effects on the company’s financial statements. The proposed rules to a large degree would prevent this by treating all leases with a term over one year as capital leases.

The proposed new standard treats the execution of a lease as the conveyance to the tenant of an asset — the right to use the property — and the creation of a liability — the obligation to pay rent over the term. The standard creates one analysis for the inception of the transaction and a slightly different one for ongoing reporting. It also requires both landlord and tenant to adjust underlying assumptions about the future of the lease as facts that might affect those assumptions change.
Tenant Changes

For the tenant the new standard would require the following considerations.

    * At the beginning of the lease, the tenant must recognize as a liability the present value of all lease payments it is obligated to make, taking into account any extension or termination options it is likely to exercise, and estimating any contingent rent or termination payments it expects to make. The discount rate to be used for the present value calculation is the interest rate the tenant would have to pay a lender for a comparable real estate secured loan.

    * The tenant recognizes the right to use the property for the term of the lease as an asset, measured, at the beginning of the lease, at the present value of the lease payments, plus the “initial direct costs” it incurs in negotiating the lease, for example, broker’s commissions and legal fees.

    * During the term of the lease, the tenant amortizes the right to use the property over the shorter of its remaining useful life or the term of the lease.

    * During the term of the lease, the tenant must reflect any changes as they occur. For example, if, a few years into the lease, a tenant’s business changes so as to make it likely that it will pay more contingent rent over the term of the lease, its financial statements must immediately reflect that change. Or, if a change in the tenant’s business makes it more likely that it will not exercise an extension option it previously expected to exercise, it may be required to adjust its financial statements to reflect that.

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