We recently wrote about expected changes to the rules governing the way leases are accounted for on balance sheets and suggested the changes would have major implications for retailer tenants and longer term implications for landlords.
Late last week, as expected, the Financial Accounting Standards Board (“FASB”) issued a suite of now final rule changes related to lease accounting. FASB is the private, non-profit organization that establishes the rules governing generally accepted accounting principles (“GAAP”) used in the United States.
Under the new accounting rules, the former distinction between (a) capitalized or financing leases, which generally are reported as assets and liabilities on the tenant’s balance sheet, and (b) operating leases, which have not historically been so treated, will be eliminated. After these new rules become effective, a tenant under a real estate lease must now include the lease on its balance sheet, even where the lease was treated as an operating lease under prior GAAP rules.
The most significant FASB change would require all tenants to include any lease greater than one year as a liability and an asset on their balances sheet. The amount of the liability would be the present value of the total rent remaining due under the lease, however, there may be some unexpected consequences as the new rules are fully implemented.
Although the content of the rule changes is final, the new rules do not go into effect right away. Instead, most publicly traded companies will have to begin to adopt the new accounting rules for fiscal years beginning after December 15, 2018. All other entities will have to begin to adopt the new accounting rules for fiscal years beginning after December 15, 2019.
The new rules are the subject of some controversy. For example, some tenants could face concerns with respect to corporate financing under the new rules because newly-disclosed lease liabilities could cause violations of existing lending covenants regarding balance sheet ratios. (Some lenders, cognizant that these proposed changes have been in progress for many years and could be adopted at any time, have been willing to “grandfather” in the existing GAAP rules into loan covenants. This practice allows a borrower to keep its leases off-balance sheet for the limited (though important) purposes of its loan covenants even after the rules change.) The rule changes could also change some of the dynamics of lease negotiations in the future as tenants will generally be able to continue to keep variable payments off balance sheet.
Despite some dissent, in general the new rules are generally understood to increase transparency in financial reporting.