The Financial Accounting Standards Board (FASB), and its international counterpart, the International Accounting Standards Board (IASB), have taken the next step toward finalizing the new lease accounting model. On August 17, 2010, FASB and IASB (collectively the "Boards") released an exposure draft of the new lease accounting standard, which is the last step before the Boards issue the final standard. The exposure draft will be open for public comment until December 15, 2010, and upon conclusion of the comment period, the Boards will revisit significant matters and issue a final lease accounting standard. Although no fixed date has been determined for the issuance of the final standard, it is generally expected that the final standard will be issued mid-2011 and could become effective as early as 2012.
The exposure draft details the latest proposed lease accounting changes, updated with modifications made based on feedback received during the comment period for the discussion paper issued by the Boards in March 2009. The exposure draft retains the guidance that was released earlier and establishes a single method of accounting that requires companies to record nearly all leases on their balance sheets as a "right of use" asset and as a corresponding "future lease payment" liability. Another key component is that companies would be required to record the lease value or rent commitment over the entire lease term, including renewal options.
Under current International Financial Reporting Standards and U.S. Generally Accepted Accounting Principles (GAAP) guidelines, accounting treatment of real estate and other leased assets differs depending on how the lease is classified. Leases that are classified as "capital" or "finance" leases are accounted for as a sale and included on the tenant's financial statement. Leases classified as "operating" leases are not recorded as assets or liabilities on a tenant's balance sheet. If adopted, the new accounting rules would require almost all leases to be capitalized on a company's balance sheet.
In a joint statement, IASB and FASB indicated the proposals will greatly improve the information available to investors about the financial impact of lease contracts. The proposed accounting changes will also have a significant impact on corporate decisions to lease or purchase real estate in the future and many commercial real estate industry analysts have said that the proposed rules will have a significant, and mostly negative, impact on commercial tenants and landlords. The Real Estate Roundtable, a trade group, is concerned that the new standard will put more pressure on companies to sign shorter leases and impede building owners' ability to obtain long-term leases that are often integral to their financing strategies.
Although the changes are not likely to take effect until 2013, it appears that companies are already factoring the proposed accounting changes into their real estate decisions. According to the Atlanta Business Chronicle and the Wall Street Journal, the recent decision of Northrop Grumman Corp., one of the world's largest defense contractors, to buy rather than lease its new corporate headquarters in Northern Virginia was not based primarily on "location, location, location," but more likely "accounting, accounting, accounting." Gaston Kent, Vice President of Finance with Northrop, is quoted in the Wall Street Journal column as saying, “Buying made sense, anyway; it just made more sense in light of the rules.” Gaston was referring to the proposed accounting rule changes. Northrop took into consideration the low cost of borrowing money and proposed new accounting standards that could make it less advantageous to lease real estate.
While the full impact of the proposed accounting rule changes is unclear, it is critical for landlords and tenants to become familiar with the new standards and to factor the changes into their decisions today. Companies will need to become familiar with the new rules in order to: (i) effectively analyze whether to lease or purchase real estate; (ii) understand the potential impact of leasing versus owning real estate to their financial ratios and debt covenants; and (iii) understand how underwriters, analysts, and banks will treat the new lease liability when underwriting and analyzing deals.