Preparing for the upcoming change in lease accounting

There is a big change on the horizon relative to how a company must account for its leases.  Based on pressure from the SEC and other stakeholders, the Financial Accounting Standards Board (FASB) has issued a new standard requiring the “off balance sheet” liabilities associated with leases be recorded on a company’s balance sheet.

If you remember the high profile financial failures of companies like Enron and WorldCom you will likely recall they had significant off-balance sheet liabilities, which their investors knew little or nothing about. Influenced by these events and the desire for better transparency for the users of corporate financial statements, the SEC and the FASB focused on bringing such off-balance sheet liabilities on to the balance sheet, which includes the liabilities associated with leases.  The end result being the newly issued lease standard by the FASB is generally requiring all leases be recorded on a company’s balance sheet. (Note: The International Accounting Standards Board (IASB) has worked in conjunction with the FASB on this topic and has issued its own Leases standard.  This article will focus on the new FASB standard.)

To help clarify these changes and explain what companies can do in order to prepare for the new standard and what impact the new standard could have on go-forward real estate strategies, we sat down with Jeff Beatty, one of the country’s leading subject matter experts on the topic who heads up CBRE’s Global Task Force on Lease Accounting.

Evergreen Trading: So, what is the big picture regarding the change to lease accounting?

JB: The change is that all leases will now have to go on a company’s balance sheet. Not just real estate leases, but leases of automobiles, copy machines, planes, and anything else that is considered a lease.

Evergreen Trading: Any exceptions to what must go on the balance sheet?

JB: Yes, there is one exception. It is for what the FASB is defining as short term leases, which are leases with a lease term of 12 months or less. It is also important to note that existing leases are not grandfathered in under existing accounting standards.

Evergreen Trading: When does this take effect?

JB: Well, the effective date for all public companies is 2019 and for private companies it is 2020; however, a company can early adopt the standard at any time.

Evergreen Trading: That sounds a long ways off. Should this be of concern to companies right now?

JB: Good question. You have to remember that public companies will have to restate comparative periods in their financial statements once they issue their initial financial statements after the effective date. So for example, if a public company has an effective date of calendar year 2019, they’re going to have to restate the prior year on their balance sheet and the two prior years on their P&L. This means leases entered into today are going to have an impact on a company’s balance sheet. And that’s primarily because in the U.S., the FASB is requiring all companies to transition to the new standard using the Modified Retrospective Approach. Basically, this approach requires any existing lease to be capitalized at the earliest date presented on a company’s balance sheet based on the remaining lease payments.

Evergreen Trading: You referenced the amount to be capitalized. Without going into a lot of details, how is the amount determined that goes on the balance sheet?

JB: The amount that goes on the balance sheet is essentially the present value of the rent payments that are to be paid over the term of the lease. That value will go on your balance sheet as both a Right-of-Use asset and as a lease liability. There are nuances to this calculation, but that is the big picture answer.

Evergreen Trading: So, again, at a big picture level, how does this change impact a company’s P&L?

JB: For companies reporting under U.S. GAAP, there’s going to be minimal, if any, changes to the P&L, because under the new lease standard there will continue to be two lease types: operating leases and finance leases.  Finance leases are simply the same as today’s capital leases; they have just been re-named.  They will have the same P & L treatment as they do currently, which is a front-end loaded expense pattern.  From a P & L perspective, an operating lease under the new standard will be treated the same as today’s operating lease with a straight-lined rent expense.  As both lease types will have the same P & L treatment under the new standard there should not be a significant impact to a company’s P & L as a result of the new standard.

Evergreen Trading: What about the impact to a company’s balance sheet?

JB: Today’s capital lease is recorded on the balance sheet and the new standard will continue to require that a finance lease be recorded on the balance sheet as well.  The difference lies in the balance sheet treatment of operating leases.  Under current lease accounting, an operating lease is not recorded on the balance sheet, whereas under the new standard it will be required to go on balance sheet.  This change to the accounting treatment of operating leases is really the crux of the change to lease accounting by the FASB.

Evergreen Trading: What should companies be doing now to get ready for the new standard?

JB: Number one, I recommend they physically find all their leases, which is not as easy as it sounds in cases with decentralized operations and locations scattered around the country. Locate all your leases and, if possible, centralize and abstract them so that the pertinent information required by the new standard is pulled out of the leases and can be easily accessed either for calculations, disclosures and/or administrative requirements demanded by the new standard.

Second, I encourage companies to initiate a dialog with their auditors because it’s going to be important that a company and their auditors are on the same page as there are several areas where judgment calls will be required.

Most companies can also begin to estimate the financial impact to their balance sheet as a result of the new standard. This will allow them to understand the impact the new standard will have on their financial ratios and, at the same time, know whether they may be in violation of any of their debt covenants as a result of their increased balance sheet.

Lastly, I will say that companies should be thinking about the processes and flow of information that will be required by their company as a result of the new standard. While the details of it are too involved for this interview, I’ll just mention that there’s a lot of information that will now have to flow between various divisions of a company.  I think it is important for a company to flowchart the required sharing of information between divisions to ensure the process is efficient and to identify new stakeholders in the lease accounting review/approval process.

Evergreen Trading: What impact, if any, do you think this change will have on a company’s real estate strategies?

JB: Well, there could be several. The first is the lease versus own decision. This will not be the case for every company, but could come into play for those who currently lease free-standing buildings on long-term leases and who have the capital to acquire an asset and are in that stage of the company’s growth pattern where it may make sense to invest capital into bricks and mortar and benefit from the assets appreciation over time. If it is going to be on your balance sheet whether you lease it or own it, maybe it will just make sense to own the asset in some cases.

Another area that most people bring up when they hear about the new standard is that companies will begin to shorten the length of their leases to reduce the impact to their balance sheet. My answer is that while there will most likely be some companies that go down this road, I think most companies will continue to do what is in the best interests of the company and let the accountants account for it appropriately.

Keep in mind that even though the company might want a shorter lease term, the landlord usually does not and the result will most likely be a higher rent per square foot for the company, fewer landlord concessions and a reduced tenant improvement allowance.   At the end of the day, I don’t think lease terms will be significantly impacted.

Evergreen Trading: Are there any other areas that you think might be impacted by the new standard?

JB: One other area is what I’ll call workplace strategies – the efficient use of space by a company. While that has been under pressure for several years now, it will be an area with a greater spotlight put on it as a result of the new standard. That is because the amount of square footage a company leases will now have a direct impact on their balance sheet. So the efficient use of space will become an area in which companies will want to continue to focus on going forward to, again, minimize the impact to their balance sheet.

 

Jeff Beatty is the Senior Managing Director for the Financial Consulting Group (FCG) of CBRE and has been the Director of CBRE’s Global Task Force on Lease Accounting since its inception in 2010. Jeff joined CBRE in 1997 and as the head of the Financial Consulting Group he oversees 65 financial analysts who support the clients of CBRE by developing financial strategies and preparing financial analyses affording companies to make the optimum financial based decision that best aligns with their corporate strategies. 

 

About Mike Lake

Mike is the Senior Vice President of Marketing for Evergreen Trading. When not playing jazz trombone he is probably obsessing about writing content that will capture the attention and interest of business people and fellow learning junkies everywhere.

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