New rules for leases will have serious effects

Chris Stephens

Big changes are coming for companies with leases. Rules that govern how businesses record leases in their financial books are being rewritten. These accounting changes could affect financial statements by as much as a trillion dollars and have a major effect on commercial real estate.

The U.S. Financial Accounting Board sets accounting rules for the nation. The proposed rule changes are designed to align U.S. accounting for leases with accounting rules in Europe and other countries. The rule changes are also supposed to improve the financial reporting of companies in this country.

Final rule changes are being evaluated and are expected to go into effect during the next two years. These changes are significant. Companies need to start evaluating now how the changes may affect their financial statements and operations.

Under the current rules, companies that lease space as tenants can record the lease either as an "operating lease" or a "capital lease."

Most leases are recorded as operating leases. With an operating lease, the rent payment is recorded as an expense, like other expenses to operate the business. But this accounting doesn't show the entire picture. Neither the benefit of the lease nor the future obligation of the company under the lease is shown on the company's financial statements. This is sometimes called "off balance sheet" accounting.

In a capital lease, the lease is recorded on the balance sheet as both an asset and liability for future rent obligations. Instead of the rent being recorded as an expense, depreciation of the lease asset is recorded.

Critics say that operating leases do not accurately show a company's financial obligations, because of the off balance sheet accounting. They are right.

So the accounting board is changing the rules to require that all leases be recorded as capital leases. Existing leases will not be grandfathered in as operating leases; all leases will have to be changed to capital leases.

Landlords are affected also. A lot of business properties are leased under a net arrangement: The property owner just collects rent and the tenant is responsible for all operating costs of the property. Landlords will be required to change how they record leases depending on several factors: how they value the property, and how much risk and/or benefit the landlord has under the lease.

These rule changes are a big deal. The Securities and Exchange Commission estimates that under the proposed rule changes, public companies will add $1 trillion of assets and liabilities to their financial statements. This also will change the timing of when lease expenses are recorded on a company's income statements.

All this is going to upset many of the traditional financial measures used to evaluate companies. The rule changes will affect how companies structure debt, evaluate leasing versus owning, determine the length of leases and renewal options, and much more.

For example, inflating assets and liabilities on a balance sheet could cause a deterioration of important financial ratios, even though a company's business activities remain unchanged. At the same time, some financial measures could actually improve.

The rule changes will result in some companies becoming noncompliant with mortgage covenants that stipulate maintaining certain financial ratios and credit scores. Those mortgage requirements will need to be renegotiated, taking into consideration the rule changes and their effect on a company's financial statements.

Under operating leases, the accounting now is fairly simple. But under the new rules, accounting departments are going to face a more difficult task in recording leases on balance sheets. Tax effects also will need to be evaluated.

Commercial real estate will be affected too. Landlords will have to learn how to structure leases so companies are comfortable with them under the new rules. Companies are going to pay close attention to how leases are structured and the effect on their balance sheets. They may want shorter leases to minimize the amount of lease asset and liability added to their balance sheet. Shorter leases will mean higher risk to the landlord and, as a result, higher lease rates. Shorter leases will also make financing new construction more difficult.

There is a great deal being written about the consequences of the proposed rule changes. I am sure there will be significant unintended consequences as well. More information is available from accounting firms and online.

Chris Stephens, CCIM, is a local associate broker specializing in commercial and investment real estate. His column appears every month in the Daily News.