CFO’s around the world should take notice of how the upcoming changes to the Financial Accounting Standards Board (FASB) treatment of leases on financial statements will be changing balance sheets and profit and loss statements (P & L’s) for businesses.  These new FASB changes are being implemented to provide more transparency by businesses that have long term leases for space. 

The originating cause of these upcoming FASB revisions dates back nearly 15 years to the Enron and WorldCom implosions caused by hidden, off balance sheet liabilities and the subsequent implosion of those companies. Here’s a brief overview of what companies will be affected and when:

• FASB changes impact both public and private companies, including non-profits.
• Public companies will use the new standard starting in 2019.
• Private companies will use the new standard starting in 2020.
• A two year look back set of records is required, so businesses need to account for the changes starting two years prior to their full implementation date noted above.

So, what exactly are we talking about?  Currently, most space leases for office or industrial space are classified as operating leases and the impacts to financial statements of operating leases generally only pertain to the P & L.  There is an expense of having a lease in the current calendar or fiscal year, but the future liability of the same lease has not been noted on the balance sheet.  The new FASB requirements outline that these operating leases will now need to be recorded on each company’s balance sheet to provide transparency that this future payment obligation / contract exists.  This is the primary change.  Say good-bye to off balance sheet.

The result of this change is that the balance sheet of all companies will be growing.  The future lease liability will be recorded on the balance sheet and then a corresponding “Right of Use” asset will be the offsetting entry.  However, these entries will not necessarily be equal amounts and so companies will experience a higher level of liabilities as compared to assets at the beginning of lease terms, negatively impacting common financial ratios that all businesses use.  This is especially important for companies with capital reserve requirements, like insurance companies and banks.

So, other than recording the lease on the balance sheet, what else is there in these new FASB regulations?  Here’s an interesting twist.  In addition to recording all years of the current lease term for each and every lease, businesses also need to record future options to renew the lease.  Say what?  While there is some subjectivity about whether the renewal option years will need to be recorded on the balance sheet, it is likely that most renewal options will need to be recorded.  So, if you have a new 10-year lease with a 5-year option to renew, it is likely you will record 15 years of lease liability on the balance sheet under the new accounting rules if these standards were in effect today.

So, what is the impact to companies that lease space?  There are multiple issues that the new regulations will create:

• Companies will have financial ratio impacts which could limit borrowing capability or require increased capital reserves.  Banks and insurance companies will certainly be impacted.  The good news is that most of these lease liabilities won’t be classified as debt and thus won’t impact those ratios, expect for businesses using IFRS, which is further detailed below.

• At the transition point, companies will have a balance sheet liability that is greater than the asset.  Over time, this will reverse itself as the lease gets closer to the expiration date.  BUT, as about 70% of companies renew their leases, this future benefit where the asset value will be greater than the liability value will in most cases never be fully realized because most leases are extended or a new space is leased prior to the expiration of the current lease.

• International companies reporting under IFRS (International Financial Reporting Standards) will record all leases as finance leases, which will create an even larger differential on the balance sheet and also on the profit and loss statement in the effective year.  This is because the lease entry for the current year expense will also include interest and amortization expense that is front loaded on a lease.  While each company’s exposure will be different, this could be a 10% to 20% increase in reflected lease expenses in the first year of the new FASB adoption. IFRS companies will also need to address the impacts of these finance leases as the liability on the balance sheet will be classified as debt and thus impact their debt ratios.

If your company has a lease expiring or new space requirement in the next few years, it’s critical to understand how these accounting changes will impact your company’s financial statements, earnings, and valuation.  There are opportunities to reduce the financial statement impacts by being proactive and negotiating transactions that take all of these new FASB elements into consideration, but it’s important to start reviewing your situation now.  For more information about how these new changes will be impacting your organization, contact an ITRA Global member.

ITRA Global is an organization of real estate professionals specializing in representing commercial tenants and buyers in the leasing, acquisition and disposition of office, industrial and retail facilities. With coverage in major markets around the world, ITRA Global is one of the largest organizations dedicated to representing tenants and occupiers of commercial real estate. Clients benefit by having an experienced professional as their trusted advisor, providing conflict-free representation with total objectivity. To learn more about conflict-free representation and ITRA Global locations, please visit the ITRA Global web site.

Article submitted by Wayne Teig of ITRA Global / Minneapolis – St. Paul, Minnesota, USA.