New Accounting Rules To Turn Leasing Market Upside Down

Heard about the new accounting rules as they apply to commercial leases?

Your accountant may or may not have, BUT the new standard taking shape could change the way tenants choose to lease space. Further, there are broad implications for the commercial real estate market.

The Financial Accounting Standards Board, which sets American standards, has been working with the International Accounting Standards Board to merge its generally accepted accounting principles (GAAP) with international standards. No big deal you might think. At issue is a major piece of the puzzle -- the accounting for leases.

The two boards have come up with a new standard that will be enacted in 2013 that, and here is the part to which you should pay attention, will require companies to book leases as assets and liabilities on their balance sheets. Under current accounting rules, American and internationally based companies list many leases as footnotes in their financial statements. The result? Public companies will have to put an estimated $1.3 trillion in leases on their balance sheets, according to estimates by the Securities and Exchange Commission.

Because many private companies also follow GAAP accounting, the number could be closer to $2 trillion, according to experts quoted by the New York Times.

Simply put, public companies will suddenly have to record much higher rent, and will have to record this as a significant liability on their balance sheets. And, according to the proposed rules, there will be no grandfathering clause when the new standard goes into effect so active leases will have to be recorded on the balance sheet. Further, companies will record as a liability the cost of rent over the remaining term of the lease and record as an asset their right to use the space.

Confused?

The implications are many and are still being debated. Some companies could become more weak in the eyes of investors, which could activate debt covenants with lenders. This situation could impact credit ratings. Interestingly, ratings agencies say they already take into consideration rent obligations. But the new standard requires additional disclosures that might well shed new light on lease terms.

Accounting for existing leases and lease renewals will also create a new set of problems. If there is a 10-year lease, the rules will require putting twice as much debt on the balance sheet as a five-year lease, so companies may elect to go with a short-term commitment. On renewals it becomes more complicated. Many firms sign leases with renewal terms, such as a 10-year commitment with an option to renew for another five years. Under the new standard, if the company is likely to exercise its option to renew, it must account fo rthe lease as it it were actually 15 years. Which means adding more debt to the balance sheet.

Doesn't sound good for lease renewal options does it?

And retailers with leases that state they owe a percentage of sales to the landlord would have to estimate their sales numbers over the entire term of the lease to book it on the balance sheet. Retail experts say this looming paperwork blizzard is causing some serious panic in retail boardroom these days. As if how to get more people to buy more stuff wasn't enough of a challenge.

The purpose of the change is to stop "significant off-balance-sheet activity for leases," said Russell G. Golden, technical director for FASB in an interview with the Times.

Mostly likely to be affected? I am thinking it will be companies that already have heavy, heavy debt loads and are in a struggle, as well as large retailers that have thousands of leases. Further, some experts believe commercial banks with multiple branches may also be hard hit when the rules roll out in 2013. And it is no secret that many financial institutions are still reeling from the economic problems the U.S. currently faces.

To the good, the new rules allow companies that lease space to assume that they are buying the right to use the space for a certain period of time. While firms will record their rent as a major liability at the start of the lease, over time they will eventually reduce this debt over the term of the lease.

No matter what you think of it, most experts call this a looming administrative nightmare. We will see . . .