Heeding Complaints Regarding Lease Standards

Two international accounting authorities appear to be moving to scale down proposed new standards that would require landlords and tenants to account for real estate and equipment leases as assets or liabilities on their balance sheets. Many in the commercial real estate industry regard the new rules as onerous, dramatically increasing the complexity of leases for both landlords and tenants.

At a joint meeting in London of the Financial Accounting Standards Board (FASB) and its Europe-based sister group, the International Accounting Standards Board (IASB) last month, the panels directed their staffs to find an approach that would classify leases as either "finance" or "other-than-finance" contracts -- very similar to the current rules which distinguish between capital , or finance, and "operating" leases. The boards are still seeking feedback from different industries on the types of leases affected by the rules, in fact, the very definition of a lease.

The FASB/IASB released an exposure draft last August proposing that companies be required to record nearly all leases on their balance sheets as "right of use" assets, and as corresponding "future lease payment" liabilities. The panels said in a statement last summer that the proposals would greatly improve the information available to investors about the financial impact of lease contracts.

However, CRE leaders have criticized the proposed new rules, arguing that the proposals could damage both the industry and the gradual real estate market recovery. Among other problems, they said the rules could throw a wrench into capital markets by encouraging tenants to sign shorter term leases, making it more difficult for owners to achieve the longer lease commitments favored or required by lenders and investors under lending covenants.

While current rules distinguish between operating lease and capital leases, the premise of the new rules is that all leases, no matter the duration or terms, should be recorded on the balance sheets of both the lessor and lessee as an asset and liability. The rules would particularly challenge tenants, who would be forced to place a value on estimated future lease liabilities using a complicated "expected outcome" formula. Landlords also would be subject to complex new reporting rules.

More than 780 comments on the exposure draft were filed by the Dec. 15 deadline, mainly criticizing the rules as too complex, potentially costly and likely to result in unreliable financial reporting. Respondents included nearly all of the major commercial real estate players and industry trade groups.

In an interview with CoStar, Mindy Berman, managing director of capital markets for Jones Lang LaSalle, said the FASB/IASB boards appear to be making an "about face" on some of the most objectionable of the proposed rules as they begin to understand the complexity and substance of lease contracts -- and find that parts of the proposal don't reconcile with real-world leasing practices.

"They're hearing the message from the leasing community," Berman said. "It's too early to say how it's going to affect the practice of actual leasing transactions, except that it appears it's moving in the direction of being more similar to where it is today."

Under current international financial reporting standards (IFRS) and U.S. Generally Accepted Accounting Principles (GAAP) standards, accounting treatment of real estate, office equipment or other leased assets differs depending on how the lease is classified. "Capital" or "finance" leases are accounted for as a sale and included on the tenant's financial statement. Contracts classified as "operating" leases, aren't recorded as assets or liabilities on a lessee's balance sheet.

"This may be the closest we've come to eliminating the distinction between capital and operating leases, but this subject has come up on a recurring basis and failed every time," noted Chris Macke, senior real estate strategist for CoStar Group. "If [the boards] are not going to materially change the classification of leases, it would be most cost-effective to maintain the current classifications."

Regardless of what the boards ultimately decide, "I would caution that we're not going back to where we were, because the new standards will still be capitalizing leases and they will no longer be off the balance sheet," Berman said. "There are going to be spotlights and scrutiny on leases that wasn't there before."

The February board actions reveal that the FASB "may be having a profound change of heart, or, at least, wants to move more slowly on any rewrite of the current lease accounting rules," John Hanley, a partner in the real estate practice of the Seattle office of law firm Davis Wright Tremaine LLP, wrote in a client paper. "The FASB and the IASB have decided to acknowledge that all leases are not necessarily the same."

At their most recent joint meeting on Wednesday (March 2) , the boards discussed accounting treatment for lessees involving non-tangible assets such as inventory, concessions and timber, but took no further action on leases of investment real estate. The boards, now meeting every two weeks, are likely to continue deliberations on a variety of issues for months, Berman said.

Also at the Wednesday meeting, the boards discussed possible effective dates and transition activities and outreach efforts for the new requirements once the boards deliberate and approve material changes to the exposure draft and issue revised rules. If the final standards are issued this year as targeted, the effective date would be about 18 months later, and likely no sooner than January 2013. Several IASB board members this week advanced an effective start date of January 2015 for all standards, including leases, while other IASB members said the start date should be based on the transition needs for each individual standard. FASB members continue to advocate a "no sooner than" effective date.

"They haven't even started [to discuss] the lessor accounting side, and that's a hornet's nest, so we think they're really trying to button down the lessee side," Berman noted, adding it's possible the boards could issue rules on the lessee side first and deal with the landlord rules separately.

"The changes so far are positive developments for the leasing community, but things can be changed and there are many more topics to tackle. Things are looking positive in the sense that the boards are incorporating feedback, and they're beginning to understand that there's a concept of leasing that's a 'use of space' as opposed to a financing decision. That's a pretty pivotal fundamental concept, and I think [the real estate industry] has broken through on that front."

In any case, Berman does not recommend that companies and service providers stop preparing for the new rules in the expectation that they may be delayed or that lease accounting treatments may remain materially unchanged.

Studies over the last year show that many companies are unprepared for accounting changes that could potentially add $500 billion in lease liabilities to corporate balance sheets. Most recently, a survey released in February by Deloitte found that just 7% of executives believe their companies are "extremely or very prepared" to comply with the new lease accounting standards.

"The state of companies' data on leasing is wholly inadequate for whatever the new lease accounting rules will be. Companies can't design the systems protocols yet, but they will still have to collect information and capitalize leases. They will still have to communicate between different disciplines within their companies."

Now is the time to start building the framework and thinking about the potential impact of various rule changes on lease transactions, she said.

"You're not going to go out and redesign your systems based on what [the board is discussing] today. But if you haven't done the fundamental investigation of how capitalization of leases will affect your balance sheet, and are not considering that as you renegotiate credit agreements, then shame on you. You're signing leases today that will extend well past the implementation date."