In August 2010, the Financial Accounting Standards Board (FASB) released proposed new accounting rules for real estate and equipment leases. If these rules become effective, they will dramatically change the way leases are reported in the financial statements of public and private companies and nonprofit organizations. They will have a substantial effect on the structuring and administration of leases, and on the usefulness of certain common lease terms, such as term extension options and formulaic rent escalations.

In the real estate industry, where ground, space, and equipment leases have been used since the Pilgrims for a wide range of purposes, the impacts will be significant. The proposed accounting standards will be adopted, in final form, sometime next year, with an effective date still to be determined. Once effective, they will apply to all existing leases—even though such leases may have been structured with an eye on current accounting principles—and to all new leases. It is not too late to make objections to FASB about these proposed standards—nor too early to begin planning for these possible changes.

Current standards

Today generally accepted accounting principles (GAAP) draw a fundamental distinction between an operating lease and a capital lease—a distinction that will be discarded by the new standards. Generally speaking, an operating lease is considered a transitory use, by the lessee, of the lessor’s asset. The lease does not impact the lessee’s financial statements (except that rent liability for the current year is reported on the lessee’s income statement as it accrues). The leased asset remains on the lessor’s balance sheet, subject to depreciation and other changes over time.

By contrast, a capital lease is considered the equivalent of a financed acquisition of the asset by the lessee; the value of the leased real estate or equipment must be carried as an asset on the lessee’s balance sheet, subject to a liability equal to the present value of the lessee’s future rent payment obligations. (The lessor’s financial statements also contain entries reflecting this premise that the lessor has disposed of the asset in a seller-financed transaction.)

Today GAAP distinguishes a capital lease from an operating lease by examining each lease for the presence of certain specific terms. If any of these litmus-test terms are present, the lease must be classified as a capital lease. These include an option for the lessee to acquire the leased asset at the end of the term for no further consideration or at a bargain price; a term in excess of 75 percent of the leased asset’s useful life; or an aggregate rent obligation approaching the fair market value of the asset.

Accounting industry critics say that, under current GAAP, lease transactions can too easily be structured to avoid capital lease status, causing extensive use of off-balance-sheet acquisitions of capital assets by means of long-term operating leases—and inadequate financial statement disclosure of what are essentially purchase-money financing transactions.

FASB apparently agrees. Rather than modify these distinguishing factors, it proposes to scrap the operating lease/capital lease distinction entirely and impose a new regime: “right-of-use” accounting for leased property and equipment. The effect would be to require something similar to capital lease accounting for almost all real estate and equipment leases—but with some significant differences in the details.

The New York Times has estimated that this new standard will require U.S. public companies to add approximately $1.3 trillion in currently nonreported items to their balance sheets, dramatically swelling both the assets and liabilities of the reporting companies. Privately held companies and nonprofit organizations will also be impacted.

Proposed lessee standards

The new standards will require a real estate or equipment lessee to disclose the lease on its balance sheet from the effective date of the lease.

On the liability side, the lessee will have to report the present value of all future lease payments, calculated using an “expected outcome analysis.” If—as is common today—the lease contains variable terms dependent on future decisions or events—such as a lease term extension option, a rent adjustment clause tied to future CPI, or an expense reimbursement provision that may escalate in amount over time as utility costs rise—the lessee will be required to evaluate possible alternative financial outcomes of such terms, and to weigh the probability of each, in order to calculate the amount of the reportable lease liability.

On the asset side on the balance sheet, the value of the right-of-use asset is initially reported as equal to the present value of future lease obligations, subject to certain one-time adjustments related to the cost of acquiring the lease.

These balance sheet items must be re-evaluated by the lessee, at each reporting period, in light of intervening events affecting the asset or the interest of the lessee in it. The lessee must also report, on its income statement for each reporting period, the implicit interest expense component in the accrued rental payment(s) for the period and depreciation of the value of a right-of-use asset during the period (rather than simply the rent amount stated in the lease); any impairment losses suffered by the asset; and changes in the lease-related liability attributable to intervening events. There are also new rules, based on the same premise, for the treatment of leases in the lessee’s cash flow statement.

Proposed lessor standards

The proposed standards also present more complexity in accounting for lessors of real estate and equipment. A lessor must make a threshold decision, in the first year of a lease, between two alternative methods of financial reporting for the lease. This choice will turn on whether, during or after the expected term of the new lease, the lessor will have “significant exposure” to the rights and benefits of the leased asset.

A lessor must consider many factors in determining whether it will have such exposure. These factors include the expected term of the lease, whether it may yield significant contingent rentals, whether it calls for the lessor to deliver material services, the remaining useful life of the asset, and the expected value of the asset at the end of the lease term.

Once made, that decision determines which lessor accounting method is applicable to the lease, and the decision is irrevocable. If the lessor determines that it does have “significant exposure,” it must account for the lease using a method similar to current lessor accounting for operating leases. The asset remains on the lessor’s balance sheet, valued at the present value of expected future rent payments plus a residual value.

Like the lessee, the lessor must use a complex “expected outcome analysis” to determine that present value, which calls for an analysis of the most probable lease term and the possible financial consequences of variable economic terms in the lease over time. The lessor’s balance sheet will also carry an offsetting liability for the landlord’s obligation to allow the tenant to use the asset during the lease term.

The lessor’s income statements will reflect the receipt of rental payments, and the performance of lessor obligations, over time. Like the lessee, the lessor must re-evaluate its balance sheet items related to the leased asset at each reporting period to reflect the effects of intervening tenant decisions and extraneous events on the leased asset or the lessor’s interest in it.

If the lessor concludes that, with the lease in effect, it no longer has “significant exposure” to rights and benefits related to the asset, it must use the different method to account for the lease—derecognition accounting. Similar to current capital lease accounting, this method’s premise is that the lessor has transferred a substantial portion of the value of the asset to the lessee at the commencement of the lease term. Once again, the lessor is required to use an expected outcome analysis to determine the value that the landlord must “derecognize” (i.e., remove from its balance sheet). Corresponding rules for recognition of a limited residual liability, and income reporting, based on this premise are also provided.

Criticisms of the proposed standards

Criticisms of the proposed standards have been in predictable areas. One line of complaint has focused on the difficulties inherent in making the complex forecasting of future events required by the expected outcome analysis. The judgments made and probabilities determined by accountants—usually after the lease has been put into effect—will not be readily predictable to those negotiating the lease transaction. Uncertainty about the effect on financial statements will undermine the acceptability of variable lease terms—such as renewal and expansion options—that have served the leasing community well in times of expansion, consolidation, or rapid market change.

Related to this line of criticism are complaints about the cost and time that will be required to complete the more elaborate forecasting of the economic consequences of a lease. Accountants will require more data about the terms of a lease, its performance over time, and events and circumstances potentially affecting the underlying asset. The costs of accounting for leases will unquestionably increase, for both lessor and lessee, if these proposed lease accounting standards are adopted without further modification.

Implications for the real estate industry

Real estate and other capital-intensive industries (such as transportation) will be hard-hit by the proposed lease accounting standards. Within the real estate industry, retailers and banks will be especially affected, since these businesses have traditionally used leasing to build out extensive networks of stores, outlets, and branches. Real estate leasing is so pervasive that all owners, users, and financers of real estate will be affected to some extent.

Recently, the leading real estate-related trade associations issued a joint letter1 raising a number of concerns about the proposed standards and urging FASB—and its sister organization in Europe and Asia, the International Accounting Standards Board (IASB)—to slow down this “financial reform” project. These spokesmen urged a more careful evaluation of the potential adverse effects of these changes on the commercial real estate and financial services industries, and on the credit and capital markets.

Among the concerns voiced on behalf of the U.S. real estate industry are:

Balance sheet liabilities

These new standards will require real estate lessees to bulk up their balance sheets by bringing operating leases—a form of off-balance-sheet financed acquisition of real estate—back onto the balance sheet. New lease-related liabilities—potentially substantial in amount—will be added to each lessee’s financial statements. If the real estate user is dependent on a bank line of credit, or bound by contract covenants, tied to the level of its GAAP-reported liabilities, the lessee may find itself uncomfortably close to—or over—that limit on permitted leverage. These new lease liabilities will be classified as capital expenditure obligations, which may also create difficulties under any “CapEx” limitation in the lessee’s credit agreements or other contracts.

Income statement expenses

The proposed standards will also adversely effect the lessee’s income statement, because they require a new form of expense reporting. Today GAAP requires the lessee to report its accrued rent obligation for the reporting period—normally a fixed obligation that changes only infrequently and is relatively constant in amount over the term of the lease. The proposed standards will instead require expense reporting of (i) a certain amount of depreciation of the value of the “right-of-use asset” and (ii) the “interest” component of the rent payable during the reporting period.

Because of the nature of the calculations used to determine the “interest expense” inherent in rent payments, these aggregate costs will be much greater in the early years of a lease term. In other words, notwithstanding that the lease may call for fixed and level payments of rent over the entire lease term, the reportable liability under these new standards will be front-loaded in the early years of lease terms. This will be a (potentially significant) drag on earnings in these years having nothing to do with true economic activity.

The end of lease creativity

Because of the uncertainties—and added accounting expense—associated with “variable” lease provisions, such as term renewal and expansion options, rent escalators, and other contingencies, the real estate leasing market will begin to discard such terms, with the likely result that leases will become shorter in term and more uniform.

That change may serve well successful landlords concerned about resetting building rents in an inflating economy, but it ill-serves tenants wishing to use leasing as a flexible tool to respond to changing market conditions and unexpected contractions or expansions of their own businesses. (Indeed, the complexities, uncertainties, and additional accounting expense for lessees under the proposed lease standards, and the likely reduction in flexibility of lease terms in the marketplace, may very well tilt a substantial real estate user toward the alternative of purchasing real estate, rather than leasing.)

Shorter lease terms and increased building turnover will also require real estate lenders to rethink their mortgage loan underwriting and administration practices.

Other landmines

Unusual real estate leases may yield unexpected financial statement results under the proposed accounting standards. A company that is both a building lessee and a sublessor of that space will want to carefully work through the required accounting of both transactions, which may result in asymmetry in reporting. Sale-leasebacks and ground leases will also require additional attention.

Uncertainty and expense

Finally, all users of real estate should anticipate more uncertainty in foreseeing the financial reporting results of real estate leases, and more professional expense and time associated with accounting for leases. Accountants will ask for more data regarding leases—particularly when trying to complete an “expected outcome analysis” of a lease with variable terms, tenant options, or other contingencies.

Real estate operators should anticipate the need for more careful administration of their leasing programs, more systematic data collection, and closer coordination with their accounting resources. Because the proposed standards will be applicable to all existing leases when they become effective, the real estate operator or user with a substantial existing lease portfolio should plan on a considerable, and potentially expensive, effort to “rebook” all of its current leases during the transition period between adoption of the new standards in final form and their effective date.

Next steps

FASB has announced that its current “exposure draft” of the proposed leasing accounting standards will remain open for comment until Dec. 15, 2010. Comments can be submitted to FASB online via www.fasb.org. Its current announced plan is to evaluate all comments in 2011 and to issue final standards in middle of 2011.