After nearly ten years of discussion between the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), in February 2016, the FASB issued an update intended to improve financial reporting about leasing transactions.
This update will affect companies and organizations that lease real estate and are required to provide audited financial statements. The new regulations will require organizations to recognize leases longer than 12 months on the balance sheet as an asset and liability as opposed to an operating expense. The Update becomes effective on December 15, 2018, for public companies and December 15, 2019, for all other organizations requiring audited statements.
These new rules affect a number of business and financial ratios that lenders and investors currently use to evaluate risk, strength and the profitability of various companies and organizations.
Companies are now trying to figure out the impact of these changes and how to best structure leases going forward to provide good economic practices with practices that may reduce the impact to the balance sheet. Below is a brief summary of some of the changes and their potential impact.
Leases will be capitalized over their initial terms, so the longer the lease, the greater the asset value and the liability. This may encourage some tenants to negotiate for shorter initial terms with the ability to extend the lease.
Options to renew may also have to be capitalized as part of the initial term if it can be demonstrated that it is likely to be exercised. Using “First Opportunity to Lease” clauses may be preferred.
Only base rent is capitalized. Operating costs, taxes and utilities are not. This will encourage tenants to negotiate triple net leases where the tenant pays for its share of these costs.
Fixed increases in rent (e.g. a specific dollar amount or percentage increase) will be required to be capitalized, but CPI increases are not, so using CPI may be preferred by tenants going forward.
Termination options, if it can be demonstrated that they are likely to be exercised, may limit the amount capitalized through the cancellation date.
Cash payments received from the landlord (e.g. tenant improvement allowance) reduce the amount capitalized. Landlord constructed finish is not a cash payment and does not have the same effect. If the tenant has the ability to fund or finance the improvements more cost effectively than the landlord, it may make sense for the tenant to pay for improvements in exchange for cheaper base rent or free rent.
This update is still new and companies and their accounting partners are only just beginning to figure out the impact of these new regulations. If you have any questions regarding the update, please contact your IRI representative.
This article appeared in our quarterly newsletter from June of 2016. The full newsletter is available at http://files.investorsomaha.com/download/online_newsletter_6-2016.pdf