After years of deliberation, the Financial Accounting Standards Board (FASB) set new standards for lease accounting this past February. This new rules will impact all companies in the United States that conform with general accepted accounting principles (GAAP), whether public or private. They will be required for fiscal years beginning Dec. 15, 2018 for public companies and Dec. 15, 2019 for private companies.
Currently, leases are divided between capital and operating leases. Historically, capital leases are on the balance sheet and operating leases are not. With the new rules, all leases, whether capital (renamed “finance”) or operating, will be on the balance sheet. This will cause balance sheets to swell with the addition of a “right of use asset” and corresponding “lease liability.”
The calculation for determining the amount on the balance sheet will be based on the incremental borrowing rate of a company. Because high creditworthy companies will have a lower incremental borrowing rate than a company of lesser quality, the exact same lease will impact each company differently (i.e., the higher credit company will have larger increase on their balance sheet than lower credit companies). These new rules will most likely trigger companies with large cash reserves to look more closely at their lease-versus-own decisions regarding their real estate. However, for public companies, this evaluation must also consist of whether the best long-term use of a company’s cash is to return it to their shareholders via a stock buy-back or to invest in real estate which is not part of their company’s core business function.
An issue that was in large deliberation throughout the years leading up to the new rules issuance was related directly to how it would impact the income statement. GAAP and IFRS (International Financial Reporting Standards) tried to converge on this issue, but ended up having to “agree to disagree.” The final rules provide minimal change from the income statement perspective, as those leases that still qualify for operating lease treatment will continue to be treated as straight-line rent over the lease term. The general consensus is that GAAP came up with the right answer, because most real estate leases are not, in-substance, purchases.
One area on the income statement that has been affected is the treatment of sale-leaseback accounting. Historically, any gain on sale for an operating lease would require it to be recognized over the lease term. Under the new rules, a gain associated with a sale-leaseback will be recognized immediately. Therefore, companies that have owned long-term property will more than likely have a low-book basis relative to market value, and will see a one-time (non-recurring) gain to earnings by executing a sale-leaseback transaction. This will be especially advantageous to corporations that anticipate their assets being functionally obsolete in the next 10 to 20 years. A company in this situation will be able to capture the increased market value of a long-term lease in a sale-leaseback versus a vacant sale, and will recognize a gain to earnings based on the increased market value.
Because most real estate leases require multi-year contracts, the impact of the new accounting rules should be incorporated into the strategic decisions companies are making today regarding their real estate. Understanding this impact is imperative from a financial statement, tax, capital, and real estate market decision-making perspective.
Maureen Kelly is senior managing director at Cushman & Wakefield, where she is part of the firm’s corporate finance and investment banking team. Contact her at [email protected]