A Real Game-Changer: What to Make of New Lease Accounting Rules

By Mindy Berman, Managing Director, Corporate Capital Markets, Jones Lang LaSalle Inc.

A long–anticipated draft of proposed lease accounting changes that will put all leases on the balance sheet was released on Aug. 16 by the U.S. Financial Accounting Standards Board and its counterpart, the International Accounting Standards Board. By now, most organizations are aware of the new paradigm for lease accounting and its impact on the balance sheet. The reality of the proposal is now shifting the focus to potential changes in leasing strategy and practices as well as meeting requirements for future administration of leases.

The Exposure Draft is the latest step in a long-running process to require capitalization of all real estate and equipment leases on balance sheets by recognizing the rights and obligations of lessees. Although a 120-day period of public comment follows the release of the Exposure Draft, the primary elements of the new rule are unlikely to change. A final standard is expected to be issued mid-2011.

Rather than choosing one of two methods to classify leases today—as operating or capital leases—the objective of the new approach is to recognize a liability for obligations to pay rent and a corresponding asset representing the right to use the underlying leased property.

Placing the full lease obligation on the balance sheet and the resulting negative drag on corporate earnings will have a dramatic impact on companies’ perceived financial performance. Changes in the financial reporting process will be daunting and cumbersome as companies must capture new data points and capitalize obligations based on internal evaluation of occupancy practices and use of property.

A major open question is how dramatically companies will react and how significantly they will alter the use of leases and desired lease terms. A knee-jerk response may be for companies to seek shorter term leases or favor ownership if property use will be on the balance sheet anyway. Certainly, the changes will push companies to articulate and validate the reasons why they lease such as flexibility in occupancy and preservation of capital for core business activities.

Given the principles-based approach to the new leasing standard, certain transactions such as sale-leasebacks and build-to-suit arrangements could be easier to execute than under current United States generally accepted accounting principles and may be achieved with better economic terms for tenants, more suited to their true business objectives. While the standard setters’ concerns about financial engineering of leases frame much of the new approach, these transactions may better align with corporate goals.

The new standard will disproportionately affect certain business sectors with a heavy reliance on real estate to generate revenue. Obvious industries are retail, but also commercial banking and airlines with substantial customer service operations and leased equipment. Not only is the total square footage in use substantial, but stores and branches are frequently in mall or in-line or airport locations that do not offer an ownership option. Retailers operating on notoriously thin margins will witness a substantial erosion of net margin. Additionally, due to new features that may require capitalizing renewal terms and contingent rent, total capitalized amounts will be high and occupancy expense substantially greater for leased retail space than today.

The pressure to revamp the three-decade-old leasing standard is driven by the perceived lack of transparency around off-balance sheet obligations and the complexity of current lease accounting.

Sweeping changes in lease accounting will give CRE executives a valuable opportunity to articulate the business reasons for leasing and to clarify when financial reporting is merely a subsidiary issue. Placing the focus on valued operating flexibility and preservation of capital for core business investment will help organizations navigate through the undoubtedly challenging time ahead with new lease accounting.