Proposed New Accounting Rules

The Financial Accounting Standards Board (FASB), in conjunction with the International Accounting Standards Board (IASB), is proposing a new standard for the accounting for leases that could have a major impact on the way tenants choose to lease space.

The new standard, which is to be issued in April 2011 will require companies to book the present value of all future lease payments as a liability on their balance sheets with a corresponding right-of-use asset to comply with “generally accepted accounting principles” or GAAP.

Currently, most tenants reporting under U.S. GAAP detail future lease liabilities on their financial statements rather than on their balance sheets. Currently, many companies list leases as footnotes on their financial statements rather than on their balance sheets. If the change is made, public companies (as well as private companies following U.S. GAAP will need to record trillions of dollars of existing leases on their balance sheets; the new rules contain no grandfathering clause. This will have significant implications for investors, not all favorable. In many cases the effect will be to weaken the strength of a company in the eyes of investors and could also affect credit ratings. While rating agencies already take into consideration rent obligations, the new standard requires additional disclosures that could shed new light on lease terms. Companies with heavy debt loads, as well as large retailers with thousands of leases, will be most affected. Commercial banks with multiple branches also could be severely hit when the new rules come into effect.

The accounting update could affect the leasing market because it removes many differences in the way companies account for property that they own compared to those they lease. Companies may decide to buy offices, driving down demand for leased space, according to some experts. Shrinking the term of a lease also may become more common because the longer the lease the higher debt loads on the balance sheet.

Another complication involves renewal terms. Options to renew that are likely to be exercised must be included in the lease term as if the renewal will definitely occur. This would mean adding more debt to the balance sheet. Another factor to consider are contingent rents (additional rent based on a percentage of sales or other variable). In these cases, the tenant will need to estimate the contingent rent over the entire term of the lease for inclusion on their balance sheets. This would mean adding more debt to the balance sheet and so make renewal options less popular. Another factor to consider are contingent rents (additional rent based on a percentage of sales or other variables). In these cases, the tenant will need to estimate contingent rent over the entire term of the lease for inclusion on the balance sheet.

These proposed updates represent a significant change from current for operating leases and are sure to have additional effects on tenant and landlord business strategies.

*This article originally appeared in BDO USA, LLP’s “Real Estate Monitor” newsletter (Summer 2010). Copyright © 2010 BDO USA, LLP. All rights reserved. www.bdo.com