New lease accounting standards expected to be finalized by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) in the third quarter are already a concern for CFOs, even though they’re not expected to take effect until January 2018.
The rules, which will require companies to record leases — including existing leases — on their balance sheets, will transform lease accounting with very real consequences for corporate financial statements. Proactive companies are beginning to assess their impact now, especially public companies that are required to report comparative financial data.
Under the new rules, all leases with a maximum term longer than 12 months will be capitalized on the balance sheet, meaning the overwhelming majority of all real estate leases that are currently off balance sheet will be coming on balance sheet. As a result, the traditional method of using discounted cash flow to analyze lease deals will not provide a full picture of how leases impact financial statements. CFOs will need to take a more active role in both negotiating new leases and renegotiating existing ones in order to anticipate — and mitigate, when possible — the impact of the changes.
Type A and B Leases
Under FASB’s new rules there will be two kinds of leases: Type A and B. The category in which a lease falls has important implications for the balance sheet, income statement, and statement of cash flows. For example, in the context of a real estate lease with increasing rents, leases categorized as Type A will have a greater impact on the balance sheet because the asset — also known as the “right of use asset” — will be amortized differently from Type B leases. As a result, Type A leases will have a more detrimental effect on shareholder equity, debt-to-equity ratios, and regulatory capital than the same lease if it were classified as a Type B.
Type A leases also have a different impact on the profit and loss (P&L) statement than Type B leases. The P&L profile of a Type A lease is front-loaded interest expense plus constant amortization expense. As a result, the total P&L impact is higher at the beginning of the lease term than at the end. Type B leases, in contrast, are recorded as straight-line rent expense. Furthermore, Type A leases are included within financing activities on the statement of cash flow, whereas Type B lease payments are recorded under operating activities.
There are three key tests to determine how a lease is classified. In general, a lease is considered Type A if it meets the following criteria:
- The term, including any renewal or termination options that provide the tenant with a significant economic incentive to exercise the options, represents the “major portion” of the “remaining economic life” of the building.
- The present value of the net base rent stream, including rents related to renewal or termination options that provide the tenant with a significant economic incentive to exercise those options, represents an all-but-insignificant portion of the fair market value of the leased asset.
- The lease includes an option for the tenant to purchase the building, and the tenant has a significant economic incentive to do so.
While no definitive definition of “significant economic incentive” exists, FASB and IASB have provided guidance around this issue. The first consideration is whether the presence of discounts and penalties is significant to the lessee. If so, the lessee has a significant economic incentive to exercise the options. Tenants can define “significant” for themselves, but this must be done reasonably and consistently.
Secondly, if the tenant has made alterations and improvements to its premises that will continue to have a useful life beyond the initial lease term, then the tenant may have an incentive to exercise the renewal option. Finally, if there is strategic value in a facility, such as a highly profitable flagship location, it would likely qualify as a significant incentive.
Minimizing the Impact of New Rules
Companies that are focused on their balance sheet metrics, whether due to regulatory capital requirements — such as Tier 1 capital ratios for banks, lender requirements — or valuation purposes, should take a thorough look at their lease portfolio. Over the next year, there is a window of time when leases can be restructured to improve what the balance sheet impact will otherwise be in 2018 if no action is taken.
Below are four steps CFOs should take to prepare for the new rules.
1. Begin with a strategic evaluation of the lease portfolio, starting with the largest leases, and assess how they will be accounted for under the new rules. Pay special attention to those for which there may be a significant economic incentive to exercise a renewal option, which could turn a 10-year lease into a 20-year lease for accounting purposes.
For one company we consulted with recently, including a renewal option doubled its total balance sheet liability under the new standards from $20 million to $40 million. The impact on shareholder equity increased from $4 million to $9 million, and net income took a $500,000 annual hit. This represents the impact of one out of nearly 100 leases in the firm’s portfolio.
2. Focus on reducing the spread between a lease’s liability and the corresponding “right of use” asset. The more these two items are out of balance, the more skewed the impact will be on the balance sheet and shareholder equity.
For example, when negotiating a new lease or restructuring an existing lease, attention should be paid to the rate and timing of rent increases, services that have been embedded in the base rent charges, and the impact of free rent and landlord incentives. All of these contribute to the spread between the asset and liability balances under the new rules, and can be used to design lease transactions to achieve better financial results.
3. Consider renegotiating leases now — even if they are not up for renewal. Most landlords are happy to renegotiate a lease if you extend its term. During the negotiations, ensure that any service charges for operating expenses, such as maintenance and taxes, are clearly delineated.
These expenses do not have to be recorded on the balance sheet. If they are rolled into the lease, it is often difficult to separate the expenses from rent. Throughout the negotiation process, work closely with your tenant advisor to address areas of concern with an eye toward protecting financial statements.
4. Identify the right team to help transition to the new standards, and start the strategic work now. These changes are as much a real estate challenge as they are an accounting one. Involve all of your stakeholders early, especially finance and real estate specialists (internal and external). It is important that they work together, since those in finance are often not familiar with the way real estate leases are structured, and real estate professionals often do no appreciate the accounting impact of leases.
Finally, leverage technology specifically designed to assess the impact of new rules, such as LeaseCalcs, along with existing business processes, such as lease analysis and abstracting.
By anticipating how new and existing leases will be classified and accounted for under the new standards, CFOs will be in a much better position to develop a strategy that minimizes any negative impact the lease accounting rule changes would otherwise have on financial statements.
While it will not be possible to renegotiate or mitigate the impacts from every lease, CEOs will rely on their CFOs to understand how the rules will affect the company and to offer proactive counsel on how the company should respond.
Sean Moynihan is a principal in the Office Properties Group at Avison Young in Atlanta. He can be reached at firstname.lastname@example.org.