Lucernex expert Jim Duport discusses the proposed FASB GAAP lease accounting changes.
FASB Lease Accounting
So, the GAAP rules for lease accounting are changing with the dual goals of increased transparency and full disclosure. Don’t panic yet. There are still a number of unanswered questions. FASB (the Financial Accounting Standards Board) released a DRAFT on August 17, 2010 with a request for comments by December 15, 2010. The implementation date has not even been set. I have heard dates ranging from 2012 through 2015.
Nothing has been set in stone! Once the comments are reviewed, another draft MAY be released for yet more comments. In reading the draft proposal and attending some seminars on the “proposed” changes, the only thing I am sure of is, there will be changes – sometime/someday! Many items, e.g. accounting for the landlord’s construction allowance, are not yet addressed in the current “proposal”.
Many thoughts come to mind with the “proposed” change. First, as an investor in the stock market, I like it. Current practices essentially ignore lease obligations (they currently generally show as a footnote on SEC required reports). There are a number of companies, e.g., some airlines with long-term leases on airplanes, where lease commitments do not show as liabilities on their balance sheet. Consequently, their financial metrics look better because they have understated their true liabilities.
In terms of real estate, again, I like it (excluding the renewal clause, see below). When a lease is signed, the tenant is “committed” to spend money and meet its obligations, whether you occupy the space or not. This focus on disclosure is not new. In my corporate days my company (Fortune 200) was among the handful of companies that estimated (and actually budgeted) all costs associated with signing a real estate lease. We used the phrase “It’s not just the rent, it’s the occupancy cost.” For example, when the lease was signed, in essence, the company was committing to rent the space, build it out, put in furniture, IT infrastructure, etc. We tried to include all the costs, with a understanding of what we “committed” to, rent, building/facility operating expenses, taxes, and in some cases roof rent for a satellite dish (yes I was doing deals back in those days), parking, etc.
Two items jumped out at me as I read the draft and the request for comments.
1. FASB has asked in essence for comments on – what do you think of including “likely” (my terminology and quotes) renewal periods in the rent calculation? Under the proposed draft a probability is assigned to the renewal, and it’s not just a guess or a SWAG (scientific wild ass guess). Instead you need to take into account your past history with similar properties, i.e. with a similar property do you typically renew?
The renewal likelihood is, to my mind, a major issue and opens the floodgate to honest differences of opinion. Who knows if you will renew. It may be likely up to the 11th hour, but plans, markets and distribution channels change. However, the impact of including renewals in the rent calculation is that the rent charged to the P&L in the beginning of the initial lease term will be higher because it will include the renewal rent which will be higher due the additional years and even a modest inflation in base rent.
Since including the renewals will increase the rent charged to the P&L, companies will look for creative ways around the renewal part of the rule. I am sure someone will find a work-around to the renewal, thus I think it should be modified.
The overall renewal concept is necessary since if it were not there, then everyone would do 1-year leases with renewal options. By the same token, some retail leases are for 20 years with two 20-year renewal options. Does it seem reasonable to be including the rent 60 years from now, even discounted for present value, in an income statement of costs now?
Renewal Inclusion Proposal: To make it simple, if the renewal is “expected” then use it for a rolling maximum of 10 years after the lease irrespective of the renewal term until it is or is/not exercised. Make reporting the renewal concept something that is meaningful, but not too painful.
2. Another issue is with the recalculation of the rent obligation if there are “significant” changes. “Significant” can mean different things to different people, different companies, different size companies, and may vary depending on circumstances, e.g., need to make by numbers this quarter. The concept of “significant” is too nebulous.
Retail leases with a percentage rent clause will be re-doing their balance sheet rent calculations quarterly. Balance sheet metrics will become much more variable vs. how they are now.
For those leasing office space, under a Full Service lease, i.e., a lease that includes a Base Year, typically you will not know the Base Year amount until sometime after the landlord reconciles his costs after December of the Base Year. Meaning, sometime in the first quarter of the year following the Base Year, the rent calculations will need to be re-done, and rent as charged to the P&L may increase. I do not see any way around this issue, except to switch over to an Expense Stop; and as a former CRE Manager, Expense Stops are horrible and only favor the landlord.
Bottom Line: Don’t Panic. Change is coming, but then change is always happening. In terms of the new lease accounting rules, ALL we know is change is coming, we do not know when, and we do not know exactly what changes since FASB is asking for comments. Certainly we will have time to transition to whatever change is adopted. The goal of transparency cannot be argued, the issue is “How”?
So, these are my current thoughts. We welcome your thoughts and will share them directly and indirectly with FASB. Hang in there; check back and we will update you with a new blog when we know more and help keep you informed so that you can know and speak with the most current thinking. Trust me, we are actively monitoring the situation.