Fasb Proposed Lease Accounting Changes - Impacts on industrial Real Estate

Comparative Advantage Definition - Fasb Proposed Lease Accounting Changes - Impacts on industrial Real Estate

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Comparative Advantage Definition

The Financial Accounting Standards Board (Fasb) on August, 17, 2010 released their "exposure draft" requiring clubs to report nearly all leases on their balance sheets as a "right to use" asset, and a corresponding "future lease payment - liability".  What does this mean to your firm in layman terms?  This proposal in essence does away with operating leases; all leases (unless immaterial) would be capitalized using the gift value of the minimum lease payments.  Therefore, businesses who in the past had off-balance sheet lease obligations, must now report these obligations on their balance sheet.

A key point to reconsider with regards to the proposed lease accounting changes is that, in all likelihood, existing operating leases, signed prior to the implementation of the new rules, will need reclassification as capital leases that must be accounted for on the balance sheet. This means that real estate professionals must immediately reconsider the result that existing and planned leases will have on financial statements once the proposed rules are implemented. Since operating lease obligations can recount a larger liability than all balance sheet assets combined, lease reclassification can significantly alter the businesses balance sheet.

The impact of recording these lease obligations on the balance sheet can have many impacts, such as: businesses needing to alert their lenders as they will now be non-compliant with their loan covenants, negotiating new loan covenants with the lenders due to the restated financial statements, ratios used to evaluate a businesses possible of credit will be adversely impacted and the restatement of a lessee's financial statement once the turn takes result may result in a lower equity balance, and changes to varied accounting ratios

The conceptual basis for lease accounting would turn from determining when "substantially all the benefits and risks of ownership" have been transferred, to recognizing "right to use" as an asset and apportioning assets (and obligations) between the lessee and the lessor.

As part of Fasb's announcement, the Board stated that in their view "the current accounting in this area does not clearly portray the resources and obligations arising from lease transactions." This suggests that the final result will likely need more leasing activity to be reflected on the balance sheet than is currently the case. In other words, many, possibly virtually all, leases now determined operating are likely to be determined capital under the new standards. Thus, many clubs with large operating lease portfolios are likely to see a material turn on their corporate financial statements.

Part of the purpose for this is to coordinate lease accounting standards with the International Accounting Standards Board (Iasb), which sets accounting standards for Europe and many other countries. The Iasb and Fasb currently have expansive differences in their medicine of leases; particularly famed is that the "bright line" tests of Fas 13 (whether the lease term is 75% or more of the economic life, and either the gift value of the rents is 90% or more of the fair value) are not used by the Iasb, which prefers a "facts and circumstances" coming that entails more judgment calls. Both, however, have the idea of capital (or finance) and operating leases, however the dividing line is drawn between such leases.

The Fasb will accept public comments on this proposed turn straight through December 15, 2010.  If Fasb makes a final decision in 2011 concerning this proposed turn to lease accounting, the new rules will go into result in 2013.

Additionally, the staff of the Securities and exchange Commission reported in a report mandated under Sarbanes-Oxley, that the number of operating leases which are kept off the balance sheet is estimated at .25 trillion that would be transferred to corporate balance sheets if this proposed accounting turn is adopted.

Commercial Real Estate:

The impact on the industrial Real Estate shop would be expansive and will have a primary impact on industrial tenants and landlords.  David Nebiker, Managing Partner of ProTenant (a industrial real estate firm that focuses on assisting Denver and regional clubs to strategize, develop, and implement long-term, ample installation solutions) added "this proposed turn not only effects the tenants and landlords, but brokers as it increases the complexity of lease agreements and provides a strong impetus for tenants to execute shorter term leases".  

The shorter term leases generate financing issues for property owners as lenders and investors prefer longer term leases to gather their investment.  Therefore, landlords should gather financing for purchase or refinance prior to the implementation of this regulation, as financing will be considerably more difficult the future. 

This accounting turn will growth the administrative burden on clubs and the leasing selected for single tenant structure will effectively be eliminated.  John McAslan an join together at ProTenant added "the impact of this proposed turn will have a primary impact on leasing behavior. Lessors of single tenant structure will ask themselves why not just own the building, if I have to report it on my financial statements anyway?" 

Under the proposed rules, tenants would have to capitalize the gift value of virtually all "likely" lease obligations on the corporate balance sheets.  Fasb views leasing essentially as a form of financing in which the landlord is letting a tenant use a capital asset, in exchange for a lease payment that includes the primary and interest, similar to a mortgage.

David Nebiker said "the regulators have missed the point of why most businesses lease and that is for flexibility as their workforce expands and contracts, as location needs change, and businesses would rather invest their cash in producing wage growth, rather than owning real estate."

The proposed accounting changes will also impact landlords, especially firm that are publicly traded or have public debt with audited financial statements.  Mall owners and trusts will required to achieve determination for each tenant settled in their structure or malls, analyzing the terms of occupancy and contingent lease rates.

Proactive landlords, tenants and brokers need to forewarn themselves with the proposed standards that could take result in 2013 and begin to negotiate leases accordingly.

Conclusion:

The end result of this proposed lease accounting turn is a greater yielding burden for the lessee as all leases will have a deferred tax component, will be carried on the balance sheet, will need periodic reassessment and may need more detailed financial statement disclosure.

Therefore, lessors need to know how to structure and sell transactions that will be desirable to lessees in the future. Many lessees will perceive that the new rules take away the off balance sheet benefits Fasb 13 afforded them in the past, and will conclude leasing to be a less useful option. They may also see the new standards as being more cumbersome and complicated to list for and disclose. Finally, it will become a challenge for every lessor and industrial real estate broker to find a new coming for marketing industrial real estate leases that make them more enthralling than owning.

However, this proposed accounting turn to Fas 13 could potentially stimulate a lack luster industrial real estate shop in 2011 and 2012 as businesses decided to purchase property rather than deal with the administrative issues of leasing in 2013 and beyond.

In conclusion, it is recommended that landlords and tenants begin making ready for this turn by reviewing their leases with their industrial real estate broker and discussing the financial ramifications with their Cfo, face accountant and tax accountant to avoid possible financial surprises if/when the accounting changes are adopted. 

Both David Nebiker and John McAslan of ProTenant indicated their whole corporate team are continually educating themselves and advising their clients about these possible changes on a pro-active basis.  

Addendum - Definition of Capital and Operating Leases:

The basic idea of lease accounting is that some leases are merely rentals, whereas others are effectively purchases. As an example, if a firm rents office space for a year, the space is worth nearly as much at the end of the year as when the lease started; the firm is simply using it for a short duration of time, and this is an example of an operating lease. 

However, if a firm leases a computer for five years, and at the end of the lease the computer is nearly worthless. The lessor (the firm who receives the lease payments) anticipates this, and charges the lessee (the firm who uses the asset) a lease payment that will recover all of the lease's costs, including a profit.  This transaction is called a capital lease, however it is essentially a purchase with a loan, as such an asset and liability must be recorded on the lessee's financial statements. Essentially, the capital lease payments are determined repayments of a loan; depreciation and interest expense, rather than lease expense, are then recorded on the wage statement.

Operating leases do not regularly affect a company's balance sheet. There is, however, one exception. If a lease has scheduled changes in the lease payment (for instance, a planned growth for inflation, or a lease holiday for the first six months), the rent charge is to be recognized on an equal basis over the life of the lease. The incompatibility between the lease charge recognized and the lease nothing else but paid is determined a deferred liability (for the lessee, if the leases are increasing) or asset (if decreasing).

Whether capital or operating, the time to come minimum lease commitments must also be disclosed as a footnote in the financial statements. The lease commitment must be broken out by year for the first five years, and then all remaining rents are combined.

 A lease is capital if any one of the following four tests is met:

 1) The lease conveys proprietary to the lessee at the end of the lease term;

 2) The lessee has an choice to purchase the asset at a business agreement price at the end of the lease term

 3) The term of the lease is 75% or more of the economic life of the asset.

 4) The gift value of the rents, using the lessee's incremental borrowing rate, is 90% or more of the fair shop value of the asset.

Each of these criteria, and their components, are described in more detail in Fas 13 (codified as section L10 of the Fasb Current Text or Asc 840 of the Codification).

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