How Do You Calculate Operating Cash Flow From Income Statement FASB Proposed Lease Accounting Changes – Impacts on Commercial Real Estate

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FASB Proposed Lease Accounting Changes – Impacts on Commercial Real Estate

Introduction:

On August 17, 2010, the Financial Accounting Standards Board (FASB) released its “exposure draft” requiring companies to record nearly all leases on their balance sheets as “right-of-use” assets and corresponding “future lease payments – liabilities”. What does this mean for your business in layman’s terms? This proposal essentially abolishes the operating lease; all leases (unless significant) would be capitalized using the present value of the minimum lease payments. So, companies that in the past had off-balance sheet lease obligations must now record these obligations in their balance sheet.

A key point to consider regarding the proposed changes to lease accounting is that, in all likelihood, existing operating leases signed prior to the application of the new rules will require reclassification as capital leases to be recorded on the balance sheet. This means that real estate professionals must immediately consider the effect that existing and planned leases will have on financial statements once the proposed rules are implemented. Because operating lease obligations can represent a larger liability than all balance sheet assets combined, lease reclassification can significantly change a company’s balance sheet.

The impact of recording these lease liabilities on the balance sheet can have multiple effects, such as: businesses need to alert their lenders that they will now be out of compliance with their loan agreements, negotiating new loan agreements with lenders due to restated financial statements, ratios used for assessing the business credit potential will be adversely affected and the restatement of the lessee’s financial statement after the change takes effect may result in lower equity and changes in various accounting ratios

The conceptual basis for accounting for leases would change from determining when “substantially all the benefits and risks of ownership” have been transferred, to recognizing “rights of use” as assets and apportioning assets (and liabilities) between the lessee and the lessor.

As part of the FASB’s statement, the Board stated that in their view, “current accounting in this area does not clearly reflect the resources and liabilities arising from lease transactions.” This suggests that the bottom line is likely to require more leasing activity to be reflected on the balance sheet than is currently the case. In other words, many, perhaps almost all, leases now considered operating will likely be considered capital under the new standards. Therefore, many companies with large operating lease portfolios are likely to experience significant changes in their corporate financial statements.

Part of the purpose of this is to coordinate lease accounting standards with the International Accounting Standards Board (IASB), which sets accounting standards for Europe and many other countries. The IASB and FASB currently have significant differences in their treatment of leases; it is particularly important that the “bright line” tests of FAS 13 (whether the lease term is 75% or more of the economic life and whether the present value of the lease is 90% or more of fair value) are not used by the IASB, which prefers a “facts and circumstances” approach ” which involves more judgments. Both, however, have the concept of capital (or finance) and operating leases, however, a dividing line is drawn between such leases.

The FASB will accept public comments on this proposed change until December 15, 2010. If the FASB issues a final decision in 2011 regarding this proposed lease accounting change, the new rules will become effective in 2013.

In addition, the Securities and Exchange Commission staff reported in a report issued under Sarbanes-Oxley that the amount of operating leases held off the balance sheet is estimated to be $1.25 trillion that would be transferred to corporate balance sheets if this proposed accounting change is adopted.

Commercial real estate:

The impact on the commercial real estate market would be significant and will have a significant impact on commercial tenants and landlords. David Nebiker, Managing Partner of ProTenant (a commercial real estate firm focused on helping Denver and regional businesses strategize, develop and implement long-term, comprehensive facility solutions) added, “this proposed change not only affects tenants and landlords, but broker because it increases the complexity of the lease agreement and gives a strong incentive to tenants to conclude lease agreements for a shorter term”.

Short-term leases create financing problems for property owners as lenders and investors prefer long-term leases to secure their investment. Therefore, landlords should secure financing for the purchase or refinancing before the application of this regulation, as financing will be much more difficult in the future.

This accounting change will increase the administrative burden for businesses, and the premium for renting single-tenant buildings will be effectively eliminated. John McAslan, associate at ProTenant, added “the impact of this proposed change will have a significant impact on leasing behaviour. Landlords of single-tenant buildings will ask why they don’t just own the building, if I have to record it on my financial statements anyway?”

Under the proposed rules, tenants would have to capitalize the present value of nearly all “probable” lease obligations on corporate balance sheets. The FASB views leasing essentially as a form of financing in which the lessee allows the lessee to use a capital asset, in exchange for a lease payment that includes principal and interest, similar to a mortgage.

David Nebiker said “regulators have missed the point of why most companies rent, which is for flexibility as their workforce expands and contracts, as location needs change, and companies would rather put their money into growing revenue rather than owning real estate.”

The proposed accounting changes will also affect landlords, particularly publicly traded or public debt companies with audited financial statements. Mall owners and foundations will need to perform an analysis for each tenant located in their buildings or malls, analyzing occupancy conditions and contingent rents.

Proactive landlords, tenants and brokers need to familiarize themselves with the proposed standards that could come into effect in 2013 and begin negotiating leases accordingly.

Conclusion:

The end result of this proposed lease accounting change is a greater compliance burden for the lessee as all leases will have a deferred tax component, will be reported on the balance sheet, will require periodic reassessment and may require more detailed financial reporting.

Therefore, landlords must know how to structure and sell transactions that will be desirable to tenants in the future. Many lessees will find that the new rules take away the off-balance sheet benefits that FASB 13 provided them in the past, and will determine that leasing is a less beneficial option. They may also see the new standards as more cumbersome and complicated to account for and discover. Ultimately, it will become a challenge for every commercial real estate landlord and broker to find a new approach to marketing commercial real estate rentals that makes them more attractive than owning them.

However, this proposed FAS 13 accounting change could potentially fuel a lackluster commercial real estate market in 2011 and 2012 as companies choose to purchase property rather than deal with administrative lease issues in 2013 and beyond.

In conclusion, it is recommended that landlords and tenants begin preparing for this change by reviewing their leases with their commercial real estate agent and discussing the financial implications with their CFO, external accountant and tax accountant to avoid potential financial surprises if/when accounting changes have been adopted.

Both David Nebiker and John McAslan of ProTenant stated that their entire corporate team is continuously educating and advising their clients on these potential changes on a proactive basis.

Appendix – Definition of capital and operating lease:

The basic concept of lease accounting is that some leases are just leases, while others are actually purchases. For example, if a company leases office space for a year, the space is worth almost as much at the end of the year as it was at the beginning of the lease; the company simply uses it for a short time, and this is an example of operating leasing.

However, if a company leases a computer for five years, at the end of the lease the computer is almost worthless. The lessor (the company that receives the rent) anticipates this and charges the lessee (the company that uses the property) a rent that will cover all the costs of the lease, including profit. This transaction is called a capital lease, but it is essentially a purchase with a loan, since such assets and liabilities must be recorded in the financial statements of the lessee. Basically, capital lease payments are considered loan repayments; depreciation and interest expense, not rental expense, are then posted to the income statement.

Operating leases usually do not affect a company’s balance sheet. There is, however, one exception. If the lease agreement has planned changes in rent payments (for example, a planned increase due to inflation or a vacation for the first six months), the rent expense should be recognized on an equal basis over the lease term. The difference between the lease expense recognized and the actual rent paid is considered a deferred liability (for the lessee, if the leases increase) or an asset (if they decrease).

Whether capital or operating, future minimum lease obligations must also be disclosed as a footnote in the financial statements. The rent obligation must be divided by years for the first five years, and then all remaining rents are combined.

Rent is capital if any of the following four tests are met:

1) With a lease, ownership is transferred to the lessee at the end of the lease term;

2) The lessee has the option to buy the property at a favorable price at the end of the lease period

3) The lease term is 75% or more of the asset’s economic life.

4) The present value of the rents, using the tenant’s incremental borrowing rate, is 90% or more of the property’s fair market value.

Each of these criteria and their components are described in more detail in FAS 13 (codified as section L10 of the FASB Current Text or ASC 840 of the Codification).

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