Though the finer points of accounting rules rarely rank high on a real estate investor’s list of things to worry about, a recent change to how leases are accounted for on a balance sheet should get your attention if you are a commercial real estate tenant, landlord or investor.
The Financial Accounting Standards Board (FASB) introduced a new accounting standard (ASU 2016-02) that took effect January 1, 2019. What is this change all about?
From New Constructs
“A company can lease assets in one of two ways: capital leases or operating leases. Capital leases effectively act as debt to own the underlying asset leased. A simple analogy is taking out a loan to purchase a car or home; payments are made periodically and, at the end of the term, the asset is owned outright with the loan repaid.
Operating leases do not transfer ownership of the underlying asset, and payments are made for usage of the asset. A simple analogy here is leasing a car from a dealer; the lessee makes payments for the right to use the car, but does not gain equity in the car itself and will not own the car at the end of the lease.
Prior to this new accounting standard, GAAP required the assets and liabilities associated with capital leases to be on a company’s balance sheet. Typically, these leases are in relation to property, plant and equipment (PP&E), so the capital lease assets were recorded in PP&E while the lease liabilities were recorded in debt or other liabilities.
On the other hand, operating leases, both the assets and liabilities, were not reported on the balance sheet, despite the fact that entities were using the assets and contractually obligated to pay the lease. Also prior to this change, capital leases required separate depreciation and interest expenses, whereas operating leases required a lump-sum lease payment or rental expense. A summary of historical accounting is shown in Figure 1, below.
Figure 1: Historical Accounting for Capital vs Operating Leases
Capital Vs. Operating Lease Accounting Treatment
Source: FASB Accounting Standards Update 2016-02 (see Appendix)
The single largest change in FASB’s ASU 2016-02 is the requirement of operating leases to have the associated asset and liability recorded on the balance sheet at the present value of future lease payments. These large assets and liabilities, once hidden in the notes, will now be placed directly on the balance sheet.”
Why does this matter for the publicly traded companies? Because tenants will be required to report these large assets and liabilities on their balance sheet, it will impact return on asset calculations and debt-to-equity considerations. As a result, decision-making by tenants will likely change to minimize balance sheet contortions. While overall this is a good move to increase transparency for publicly traded companies, it will have ripple effects throughout commercial real estate leasing across the country.
Three Major Impacts for Tenants and Commercial Landlords:
- Tenants who otherwise would have been inclined to signed long term leases will now seriously consider purchasing the property instead.
- Because the visibility of lease liabilities has increased to shareholders of public corporations, the finance department of these firms will push hard for shorter lease terms with more renewal options. This will require landlords and their commercial real estate leasing professionals to get creative in how leases are negotiated and enforced. Otherwise, lease rollover risk for owners will increase.
- Payment structures will receive more scrutiny. Listing the cost of lease and non-lease components will make it easier for companies to comply with the new reporting requirement.
Commercial property owners in Missoula, Ravalli and Flathead counties would do well to consult with a commercial real estate professional and their tax and legal advisors to make sure all the implications of the FASB change are grasped. Landlords that understand how this will affect tenants and respond by offering compelling (i.e., flexible) lease structures stand to benefit from this change.
To help create a leasing strategy for your commercial property, you’re invited to contact a Sterling CRE Advisors at (406) 203-4547 today.
Disclaimer: This is not accounting or tax advice. Questions on tax or accounting rules should directed to your CPA or tax attorney.