Proposed Changes to Lease Accounting Rules Impact Balance Sheet and May Lead to Loan Covenant Violations

On May 16, FASB and the IASB announced the issuance of a new exposure draft of the proposed lease accounting rules which will have a major impact on the retail industry. This is the second major iteration of the proposed changes. (For those who may not have been following this issue, see Schmitt, Demystifying the Proposed Lease Accounting Changes. A brief (and oversimplified) synopsis of the rules follows: under the accounting rules in effect now, real estate leases are accounted for differently than many equipment leases. Those equipment leases are viewed as akin to purchases (think of a company leasing a computer system for 5 years; at the end of that time the system has little if any residual value); the entire rent stream obligation is shown as a liability on the balance sheet (with the equipment itself shown as a corresponding asset) and the income statement treats the rent expense like a mortgage payment, which acts to front-load expenses at the beginning of the lease term (i.e., creates a downward line over time) since the imputed interest is higher at the beginning of the loan. Conversely, real estate leases today are not viewed as akin to purchases; they do not appear on the balance sheet and the rent is averaged across the lease term, creating a straight line over time on the income statement.) The prior iterations of the proposed rules created an uproar in the real estate community by proposing that all leases be treated the way that such equipment leases are currently treated – that is, that they appear on the balance sheet, and that they front-load expenses on the income statement. The 2013 exposure draft backs off of one, but not both, of these positions.

Under the new exposure draft, the current income statement treatment of rent for most real estate leases is preserved – rent appears as a straight line over time on the income statement. In other words, the rent is averaged over the entire term, and the average rent appears on each year’s income statement. Thus, from income statement standpoint, under the new exposure draft the rent expenses will not be front-loaded as was proposed in the prior exposure draft.

However, the new exposure draft still requires that all leases, whether real estate or equipment, now appear on the balance sheet. The liability is the Net Present Value (NPV) of the entire rent stream, and the asset is the right to use the leased item (equipment or real estate) for the lease term. Initially, the asset and liability are generally equal – a 1:1 ratio.

This will have an impact on the balance sheet of any entity which leases real estate, and the impact will be very significant for entities which, like retail operations, lease a lot of real estate. Consider a single store of 4,000 rentable square feet (rsf) leased for five years at $50/rsf NNN without any Tenant Improvement (TI) allowance. Leaving aside NPV analysis to keep the math simple, the total rent for this single small lease is $1M. For an entity with 25 such leases, or with a single 100,000 rsf lease, the number is $25M. Most financial covenants require an asset to liability ratio that is higher than 1:1 (perhaps 1.25:1); if you add enough dollars to the balance sheet in a 1:1 ratio, the overall asset to liability ratio will be significantly lowered. Even though absolutely nothing has changed factually, the impact of the new accounting requirement may be to put some companies in violation of their loan covenants.

No leases will be grandfathered, and where comparative reporting is required companies will need to apply the new accounting rules to their existing leases for several years prior to the date that the new rules go into effect (no effective date has yet been proposed). The new rules will require extensive record-keeping and possible frequent recalculation of amounts included on the balance sheet, and will provide an incentive for doing everything possible to parse out “non-rent” items (e.g., payments for services) from the rent that must be booked.

The 2010 exposure draft drew over 800 comments. The FASB board was deeply split on whether or not to issue this exposure draft, indicating that there will likely be further extensive discussion of and possible modification to the current draft. The FASB website has a portal to make comments and the comment period for the new draft ends on September 13, 2013. Stay tuned!

Related topics: Leasing, Real Estate, Retail