Change is in the air. Specifically, major changes to the way that tenants will have to treat leases under GAAP have been proposed, and some version of these changes will almost certainly be implemented, possibly by January 2015. (Landlord changes have also been proposed, but are even more preliminary than the tenant changes.)
Under current GAAP rules, leases fall into two categories: operating leases and capital leases. Most traditional real estate leases are currently classified as operating leases. Leases which are more akin to a purchase – many equipment leases, sale-leasebacks, long term ground leases, etc. – are classified as capital leases. Under current GAAP, operating leases do not appear on the balance sheet, and the income (profit/loss) statement simply shows the average rent expense over the lease term (a horizontal line over time).
Capital leases, on the other hand, appear on the balance sheet, with an asset of the right to use the item/space in question (often set at full value, if the underlying transaction really is akin to a purchase) and a liability of the NPV of the full rent stream over the term of the lease. On the income statement they are treated more like a mortgage, with an amortization element and an (imputed) interest element. Since there is more interest in the early years of a mortgage, the line slopes downhill. (Note that actual cash flow usually slopes uphill, as rent increases over time.)
In part, the proposed changes are a reaction to the abuses of the Enron era, when purchases were transformed through sleight of accounting into off-balance-sheet transactions. (Hint: if it is actually called a “synthetic” lease, things have probably gone too far.) But the push to put all leases on the balance sheet predates the Enron debacle by quite some time, with both FASB (US Accounting Standards Board) and IASB (International Accounting Standards Board) pushing to have leases show up on the balance sheet to better reflect the actual financial picture of companies and permit meaningful comparisons between companies that lease and companies that purchase. Since off-balance sheet leases are currently noted in footnotes to financial statements, many Wall Street analysts already take them into account when evaluating companies.
What Will Change
The proposed changes are definitely in flux, so it is not clear what their final form will be. This much seems almost certain, however there will no longer be a distinction between operating leases and capital leases. All leases will be treated essentially the way that capital leases currently are – they will appear on the balance sheet, and lease expenses will be booked in greater amounts at the beginning of the lease term than at the end (a downhill line over time on the income statement). Only “true” rental expense will have to be booked; amounts that are payable for services (such as OpEx/CAM and taxes) or other items (such as landlord-provided TI allowances) will not appear on the balance sheet, though it can get complicated to tease these items out of a composite base rent.
What It Means
Before NPV analysis (to keep the math simple), the total rent for a single lease of 10,000 rsf for five-years at $35/rsf NNN without any TI allowance is $1.75M. With the new accounting rules (and ignoring NPV for simplicity), the tenant under this lease will have to book an asset of $1.75M (the right to occupy the space for 5 years) and a corresponding liability of $1.75M, and reduce them both over the term of the lease. Note that initially, the asset equals the liability – a 1:1 ratio. Since most financial covenants require a higher asset to liability ratio (perhaps 1.25:1), the new rules may throw many companies into default. Furthermore, the new accounting front-loads expenses on the income statement (creating the downhill line). The implications of this are complicated, but one thing is certain – the snapshot of profitability provided by a company’s income statement will be negatively impacted in the early years of a lease. The more real estate a company uses, the bigger the impact on both these fronts.
When It Will Happen
The current best guess is that final rules will be issued in the beginning of 2012 and the effective date will be the beginning of 2015. Note that no leases will be grandfathered – regardless of when the lease was signed, beginning on the effective date, the new rules will apply. Also, many companies have to show a three-year comparison in their financial statements, so they will have to apply the new rules to 2013 and 2014 to create comparison numbers.
What to Do Now
The final form of the rules is by no means certain, so it may not make sense to implement procedures to comply with specific features of the currently-proposed rules which may change (some companies bought software designed for the initial proposed rules, which have since changed dramatically, and regret the purchase). It does make sense to monitor the situation to keep abreast of the current proposals, and to comment on the next exposure draft if you are so inclined. You should be sure that the appropriate individuals in your company are aware of the issue, and begin to allocate responsibility for collecting the data you will need for each of your leases (term, rent, base OpEx/CAM and tax amounts, amount of landlord-provided TI allowance, etc.). Finally, you should discuss the matter with your accountant and consider his or her recommendations as well.
*Published in the CORENET newsletter in July 2011.