Contingent rents, which are lessee payments frequently tied to some variable, such as a percentage of sales or the consumer price index, would impose another burden. Contingent-rent estimates have to be updated at each quarterly measurement date, or sooner if a material change is booked. “There is a lot of look-back about what to put on the balance sheet after the initial measurement,” says Prindle, who expects real estate leases to be particularly troubling.
Judging from the draft, “FASB really does not understand what commercial tenants do,” insists Marisa Manley, president of consultancy and broker Commercial Tenant Real Estate Representation. She says the proposed rules may “fundamentally change the way tenants look at leasing…and change the relationship between tenants and landlords,” especially regarding the buy-versus-lease decision.
If the draft rules remain unchanged, she says, several things will result. First, the typical lease contract will drop from its current 10-year term, as the opportunity to amortize payments in a straight-line manner is abolished and expenses are front-loaded. And tenants will be far more careful about renewal plans, since any indication of reupping a contract would trigger a lease-term extension for accounting purposes and a longer payment obligation carried on the balance sheet. Shorter-term leases may also prompt landlords to charge higher rents, Manley says, since the stability of a long-term commitment is gone.
But the rules will have lessees scrutinizing real estate costs, and that could be beneficial because some landlords use gross payments — bundled real estate and service fees — as a profit center. (Landlords have been known to charge a 300% premium for late-night air conditioning and heating.) Still, the concern for most tenants will be trying to determine if they are in a position to abandon leasing in favor of buying.
Cash Flow Redefined
Lessee cash-flow statements will also be affected. The draft rules require lessees to classify cash payments as financing activities, rather than payables that run through operations. So, while the net effect is that actual cash flows remain the same, the accounting entry “cash flows from operations” could be affected, says Gannon, again disrupting ratios that are used to measure performance or access capital.
In addition, Oldham thinks that shifts in income could ultimately affect debt service coverage ratios, depending on the multiple of operating income and the definition of operating income written into a lending agreement. If a decline in income during the early part of a lease causes a debt ratio to sink too low, albeit temporarily, the company will have to make up the income somehow if it wants to maintain proper ratio levels.
The front-end loading of the lease expense could also result in lopsided reporting for some lessees. Bill Bosco calculates that by eliminating the straight-line method and replacing it with amortization and imputed interest, a hypothetical lessee would see expenses climb by 21% in the first year of a 10-year office lease (see related examples above). In the first 5 years of that same lease, the expense would be 63% higher than current generally accepted accounting principles.
Marie Leone is senior editor for accounting at CFO.
What motivates companies to lease? “Cash flow, taxes, convenience, and off-balance-sheet accounting treatment,” says Michael Fleming, a principal at lease-financing consultancy The Alta Group. Traditionally, protecting cash flow has been the primary reason for leasing, since a company can use a leased asset to generate revenue with no money down, and pay for it over time. The lessee may also be able to take advantage of tax breaks in the form of lower lease payments, if the lessor has enough net income to capture tax breaks from expensing or depreciation, adds Fleming. The convenience of leasing equipment quickly, and not having to worry about certain maintenance issues, has always attracted smaller, less-capitalized businesses to leasing, and off-balance-sheet treatment of assets has been viewed as a benefit to some companies, although it has never been a prime motivation, contends Fleming.
Many times, companies that claim they are looking for off-balance-sheet treatment are really just looking for lower lease payments, “so it is truly a cash-flow issue,” insists Shawn Halladay, also a principal at The Alta Group. The confusion exists because lower lease payments are often the result of a lessor creating a higher residual value, which may take the asset value off of the lessee’s balance sheet. — M.L.