HOUSTON – (By Dale King) – A Toronto-based commercial real estate services firm warns that many public and private companies will need to make significant adjustments to their balance sheets and income statements as new lease accounting standards take effect. The changes, which require companies to recognize most leases on the balance sheet, will have material implications for reported liabilities, equity, and key financial metrics.
Avison Young’s white paper, titled “The Big Change to the Lease Accounting Standards” and authored by Sean Moynihan, a principal in the firm’s Atlanta office, explains how companies should realign accounting processes and lease practices. It is particularly aimed at organizations that have not yet started preparing for the transition.
The white paper notes that the new lease accounting rules were debated for more than nine years by the U.S.-based Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), a lengthy process that “lulled companies into a false sense of security.” Despite the delay, the report warns many companies could be caught unprepared and may suffer significant enterprise value impacts if they do not act before the rules take effect.
Under the FASB timetable, the new standards became effective Dec. 15, 2018, covering fiscal years and interim periods within those years. The revised regulations apply to:
- Public business entities;
- Not-for-profit entities that have issued, or are conduit bond obligors for, securities that are traded, listed, or quoted on an exchange or over-the-counter market; and
- Employee benefit plans that file financial statements with the U.S. Securities and Exchange Commission (SEC).
For other organizations, the new FASB lease standard applies to fiscal years and interim periods beginning after Dec. 15, 2019. The IASB effective date is Jan. 1, 2019; companies may adopt IFRS 16 earlier only if they also apply IFRS 15, “Revenue from Contracts with Customers.” IFRS 16 provides guidance for companies headquartered outside the U.S. and for U.S. companies with international locations on how leases must be recorded on financial statements.
Explaining the rationale behind the changes, Charles Neuhaus, a principal in Avison Young’s Houston office, says the goal is greater clarity in lease accounting. “This will effectively require companies to put most leases on the balance sheet whereas before, they would only have been footnoted,” Neuhaus notes. He emphasizes that listing lease obligations as liabilities can be substantial and will materially change many companies’ financial profiles.
Moynihan’s report stresses that many public and private firms will be affected, though the new rules are unlikely to impact typical residential property holders or renters. Under the forthcoming standards a lease will create a right-of-use asset and a lease liability that must be recorded on the corporate balance sheet. Under FASB’s model, leases will be evaluated and categorized as either finance leases (similar to today’s capital leases) or operating leases (similar to current operating leases).
By contrast, the IASB model treats nearly all leases as finance leases. In both frameworks, leases are capitalized on the balance sheet, but the two models have different consequences for shareholder equity, EBITDA (earnings before interest, taxes, depreciation, and amortization), and reported profitability. The white paper warns that items often treated as minor—such as tenant improvement allowances and lease renewal options—can carry important accounting implications under the new standards.
Because existing leases are not grandfathered, every lease in a company’s real estate portfolio could affect financial statements. The white paper also highlights that all public companies listed on U.S. exchanges, which must present comparative financial data, will effectively need to transition to the new rules in advance of the effective date to remain compliant with SEC regulations.
The report outlines specific examples of how financial statements will change:
- Finance lease payments will be reported as financing activities, while operating lease payments will be recorded within operating activities;
- The liability recognized for a finance lease will be classified as debt, which can worsen a company’s debt-to-equity ratio and potentially breach loan covenants; and
- Shareholder equity will often be reduced more under a finance classification than under an operating classification because of different amortization and expense recognition patterns on the income statement.
Neuhaus observes that many companies are not yet addressing these issues or structuring leases with the new rules in mind. “There are certain ways to structure leases so that the change will be less impactful versus just crafting a lease, handing it to accounting and living with the implications,” he says. Proactive lease structuring and coordination between real estate and finance can reduce negative effects.
The white paper recommends a three-step risk mitigation strategy for company leaders:
- Assemble the right team, including finance and real estate specialists, to guide the transition to the new standards;
- Conduct a strategic review of the current lease portfolio to assess potential impacts on financial statements and covenant compliance; and
- Consider renegotiating leases now—even those not approaching renewal—to reduce unfavorable accounting or covenant outcomes once the standards are implemented.
May 25, 2017 Realty News Report Copyright 2017