NEW LEASE ACCOUNTING STANDARDS COULD HAVE MAJOR IMPACT

Many tenants are likely to see a big shift in their balance sheets in coming years.  The Financial Accounting Standards Board (FASB), together with the International Accounting Standards Board, has proposed a comprehensive set of changes in the generally accepted accounting practices (GAAP) for leases.

In an Exposure Draft issued August 17, 2010, which commentators say is likely to be adopted, FASB has proposed a fundamental shift in lease accounting.  Perhaps most significant is the proposed change from operating to capital treatment of leases – that is, requiring tenants to place the obligation to pay rent over the entire lease term on their balance sheets as a liability, where before only the current rent was booked on the financials, as an expense on the income statement.

In calculating the long-term rental obligation, contingent payments such as “percentage of sales” rent would be required to be estimated and included in the total.  When addressing renewal options, accountants preparing financial statements under the new GAAP standards would be required to use the longest term that is more likely than not to occur.  Tenants will discount the full stream of rent payments to present value, using their borrowing rate.
The rent liability will be offset by an equivalent asset, representing the right to use the leased premises.  Both the asset and liability totals attributable to leases diminish over time as the expense is booked.

While both sides of the balance sheet are grossed up under the new rules, many tenants – especially those with large lease portfolios – will not be happy seeing their debt loads suddenly balloon and their financial picture appear shakier.  And existing leases are not slated to be grandfathered in under current rules, meaning that the predicament may already be somewhat of a foregone conclusion for many companies.

Final comments on the proposed standards are due December 15, 2010 and final standards are estimated to be issued in the middle of 2011.  Actual implementation is estimated to be no sooner than January 1, 2013.  In the meantime, many tenants can be expected to take the new standards into account in structuring and negotiating their lease deals, as tenants seek to alleviate the impact of the new standards.  For example, large retail chains may switch to a policy of shorter lease terms in order to offset the impact of the new standards.

Scott M. Toussaint, Real Estate Group