Accounting alteration holds potentially bad consequences
A new accounting standard is likely to change the financial ratios for commercial landlords and their tenants, make it more difficult to determine the value of a lease, force every lease to be reevaluated, shorten the terms of future leases and be costly for property owners and renters alike.
Most real estate financial analysts feel the new benchmark will hold broad — and quite possibly negative — consequences for both sides of the commercial leasing market.
The accounting change is coming about because the Financial Accounting Standards Board, which sets standards in the U.S., has been working with the International Accounting Standards Board to merge its generally accepted accounting principles with the international code.
So with convergence weighing heavily on FASB’s mind, it probably means that leases will have to be booked as both assets and liabilities on balance sheets. That scenario could become the standard accounting practice here as early as Jan. 1, 2012.
“Right now, this is still in the exposure-draft mode, and FASB is requesting feedback through Dec. 15, 2010. The exposure draft doesn’t propose an effective date. But an industry expectation is it would be no earlier than calendar date 2012,” said Robert Edwards, CPA, a partner in the East Lansing office of Plante & Moran PLLC.
Edwards explained that under the current standards, there is nothing on the balance sheet of a tenant or a landlord that would recognize either had a future obligation to pay, or a future right to receive payment, on a long-term contract. Instead, everything is expensed as a lease according to the specified terms, and the agreement is footnoted in a financial statement that lists a tenant’s financial obligation or a landlord’s right to receive a payment as rental income.
With the change, though, Edwards said a landlord will have to recognize a lease payment almost as interest income because a property owner will have an asset and a liability for the future amount of a lease — meaning the present value will have to be discounted back.
“They will write off the liability and write down the asset as if they were collecting on a note receivable. So in the early years, a higher amount of it will be interest and a lesser amount of it will be writing down the asset. For longer leases, you would literally write the asset off. You wouldn’t record the asset any longer — the building or whatever it is — on the books of the landlord. You would recognize it as kind of a receivable,” said Edwards.
“It’s going to be significantly more work to record a transaction.”
But Edwards pointed out that much of the concern for property owners is that the new standard may alter certain financial ratios in their statements, such as debt-to-equity ratio, a figure that a landlord’s lender may keep a close eye on. The new standard could raise the debt portion of that ratio and make it more difficult for a property owner to find credit.
“I would like to think that the lenders who participate with these types of clients and in these types of transactions will understand the impact of these accounting changes, and that it wasn’t an operational type of change,” he said.
As for tenants, under the current standards they simply record rental payments as a lease expense. The new principle, however, also will require them to record their lease as an asset and an offsetting liability. Edwards said the asset will be written off in a straight-line depreciation basis and the liability will come off the books as a mortgage does.
“So for a 15-year lease, they would have to assume some sort of a standard borrowing rate of, say, 7 percent, then discount that so they have a lease with the exact same payment for all 15 years. They would end up recognizing much more of it as an interest expense in the early years, typically how you would do it with a mortgage,” he said, adding that the draft FASB document provides guidance on how the interest rate is determined.
Edwards said the commercial real estate industry has been fighting to prevent the accounting change from going into effect. One reason for that resistance is the new standard will make it more difficult to evaluate the effect of a lease.
“For example, if you had a 10-year lease with a five-year option to renew, in year one you’d have to decide whether to record the future obligation for the whole 10 years or for the 15 years. And, basically, it all depends on what you assess to be the most likely scenario. So 10 years from now, do we think that they’re going to exercise their option to renew? If you think they are, then you have to record it for 15 years. If you think they’re not, then you have to record it over 10 years. That’s awful hard to do,” he said.
Edwards said some people have commented that they think the new accounting standard will entice, and maybe force, parties — especially tenants — to do shorter term leases. To explain why, he gave the following example: Say a 15-year lease would cost a tenant $100,000 a year, so the lease has a potential value of $1.5 billion over its total duration. That means the lease would have to be recorded on the first day as an asset and a liability of $1.5 billion, a dangerous financial burden for most tenants to carry on their books. But if the lease was for just five years at $100,000, then only $500,000 would have to be recorded as a liability.
“So people who are trying to manage their liabilities on their balance sheets are going to be motivated to exercise shorter-term leases. For our lessor clients in the commercial market, they are not going to be very thrilled by that trend. I assume they like to get those nice, solid long-term leases,” he said.
To make matters worse, the new accounting requirement doesn’t give existing leases an exemption, as there isn’t a grandfather clause in the draft document. Due to that circumstance, Edwards said each tenant and landlord will have to reevaluate and restate every lease that is in play, just to meet the new accounting standard once it goes into effect. Having to do that will cost plenty, and Edwards doesn’t think FASB’s effort to install the new standard will be derailed.
“Our information is telling us no. There still is a comment period open until Dec. 15. There are still groups that are actively trying to get this thing changed. We’re communicating it to outside entities that they really need to start to be prepared for this,” he said.
“While we think it’s probably at minimum a year-and-a-half away from an implementation standpoint, we think there are enough signs leading toward this happening that we should be concerned about it.”