New Accounting Rules Affecting Tenants & Landlords

The Financial Accounting Standards Board and International Accounting Standards Board have been working on a project to modify how leases are reported by tenants. Currently the standards require that tenants evaluate leases to determine if they are capital or operating leases. Capital leases are recorded as Assets and related Liabilities on the company's Balance Sheet. Operating leases are expensed as the lease term passes and future lease obligations are disclosed in the footnotes to the financial statements. Most real estate leases are recorded as operating leases. The new rules will require that all leases are recorded as a right to use Asset and lease related liability, calculated using the present value of all lease payments. These "Assets" will be amortized over the life of the lease and lease obligations will be reduced as lease payments are made with an interest component to take into account time value of money. We see many possible implications of this new rule. No question these new rules will affect the company's Debt/Equity ratio, maybe forcing a company to shorten the length of its leases to meet its covenants. A shorter lease will require only a fraction of the debt to be recognized in the balance sheet. Under the rule renewal options must be included if it is likely the option the option will be exercised. Landlords also have to change the way they report leases. For leases with significant risk and benefits associated with, they will have to record a liability for the obligation to provide space and an asset for the rents to be received. For all other leases landlords will have to use the derecognition approach, meaning they will have to record a lease receivable for the future rents and a residual asset representing the lessor's right to the underlying asset at the end of the lease term. Like with the case of a tenant, the term of the lease would require auditor's judgement and must be re-evaluated at each reporting date. These new rules will affect, landlord's and tenant's, leasing decisions in the future. Commercial real estate entities must contact their accountant and business advisors regarding these changes. It is our opinion that the proposed standard will create an incentive for shorter leases, creating more volatility and affecting property values. It may also create situations where tenants may be better off purchasing rather than leasing space. All these changes and their possible effects must be discussed with a Certified Public Accountant before making any decisions.