Tenants Beware!

Investors and analysts complain that it is difficult to compare the financial positions of two entities with similar leases because financial statements often do not clearly show the effects of operating leases.  They claim that tenants under operating leases get a source of unrecognized financing.

A 2005 Security and Exchange Commission report criticized the accounting treatment of operating leases that permits over a trillion dollars of liabilities to remain “off-balance sheet” and called for the Financial Accounting Standards Board (the “FASB”) to work with the International Accounting Standards Board to revise accounting standards to “transparently and consistently” reflect the underlying economics of leases.  As a result, the FASB has proposed sweeping new real estate accounting standards.  If these changes take place, they will affect current operating leases, not just future transactions, and affect each tenant’s bottom line.

Current Accounting Standards: Under today’s generally accepted accounting principles (US GAAP), leases are split into two categories:   capital leases and operating leases.  They are not easy to distinguish because leases are structured in numerous ways.  However, office, retail, and research and development leases are typically classified as operating leases.

Presently, operating leases and capital leases are not accounted for in the same manner even when the terms are nearly the same.  A tenant records capital lease rental payments as an asset and obligation on both its balance sheet and its income statement.  This is because US GAAP assumes that a capital lease is similar to the purchase of an asset, financed by a loan.   On the other hand, operating lease rental payments are accounted for only on a tenant’s income statement.  The rental payments are charged as an expense as the payments become payable.  Contingent rental payments, such as percentage rent and rent increases based on the CPI, are charged only when they arise.

Proposed Changes: In 2009, the FASB issued Discussion Paper 1680-100 and accepted public comments. The Discussion Paper and comments are available at www.fasb.org/leases.shtml#due_process.

If the changes move forward, then further drafts will be issued over the next year or so, and formal standards could appear as early as 2011.

The proposed lease accounting standards are quite complex. The FASB determined that the tenant under a lease obtains a right to use the leased property, which meets the definition of an asset. The tenant’s obligation to pay rent meets the definition of a liability.  Therefore, the FASB tentatively decided to adopt a new model that treats all leases as capital leases, to be reported on the tenant’s balance sheet as both an asset (the right-to-use) and a liability (the payment obligation). The lease would be valued as the present value of the lease payments discounted using the tenant’s incremental borrowing rate.  The incremental borrowing rate would take into account the tenant’s credit standing, the lease term, and the nature and quality of the security.  In leases with options to extend or terminate the lease, the lease term would be confirmed through recognition – that is, the tenant would select the length of the lease term that is more than likely than not to occur and base its accounting upon that term.  The tenant’s obligation to pay contingent rent should be measured as a liability.

On the tenant’s income statement, the rental expense would be treated as depreciation and an interest payment, similar to a purchase loan obligation. The interest component would be higher in earlier years, particularly for long-term leases. The aggregate expense deduction (depreciation and interest) over the life of the lease would be the same for a capital lease or an operating lease.  However, under the capital lease treatment, higher expenses will be recognized in the early years of the lease term.

As between the landlord and tenant, the proposed accounting changes do not affect their obligations toward each other. However, because they will affect the tenant’s balance sheet and income statement, the tenant may find itself in breach of financial covenants in its other (e.g., financing) agreements. Further, because the accounting changes will affect income statements, they may trigger changes in bonuses and earn-outs.

The FASB Discussion Paper does not address whether there will be a transition period from the old standards to the new, whether there will be an exception for small leases, or how the changes will affect landlords and sublandlords (when a party is both a tenant and a landlord).

For now, real estate professionals should advise tenants to evaluate their leases as both capital leases and operating leases from an accounting perspective. Any financing or other documents with financial covenants and debt-to-equity ratios should provide that so long as the covenants are satisfied under current standards, they will not be deemed breached by the application of any new accounting standards.

This article is not intended to be a technical analysis of the proposed changes and their effects, but is an alert that these changes may be on their way.