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Copaken Brooks Advises on Accounting Rule Changes

For Immediate Release
May 2011
For Additional Information Contact
Bill Early, Copaken Brooks
816-701-5000

Corporate Real Estate-Lease Accounting Changes are Hot Topic

CFOs are shining a white hot spotlight on commercial real estate managers especially those with multiple facilities. The United States Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) initiated a joint project whereby all leases will be recognized on the balance sheet - not the income statement - beginning as early as January 1, 2012. The question is not if the changes will be approved (they will) but what changes the final version will include.

For the lessee, the asset is a "right of use" and the liability is the lease payment amortized like a loan for the term of the lease. For a lessor, the asset is the right to receive lease payments and the liability is either a performance obligation (performance obligation approach) or a reduction in the rights that are being provided to the lessee (recognition approach).

The changes will affect public companies and private companies that issue audited financial statements, borrow money, or are contemplating an IPO. Companies expected to be effected the most include retailers, financial services firms, airlines, and commercial banks. These industries will need to change their policies to capitalize billions on corporate balance sheets resulting in a substantial increase in assets & liabilities plus an increase in EBITDA.

BENEFITS
  • Greater Financial Transparency
  • Complete and Comparable Financial Ratios. Reduce ability to "engineer" results.
  • Financial statements more accurately reflect obligations.
  • Business units have more incentive to collaborate relating to how lease exposure impacts financials.
COSTS
  • Straight-lining with interest expense creates front-ending of lease costs and a declining rent curve.
  • FASB calls to revisit the assumptions “whenever it’s appropriate” at the same time that SOX says “execs are legally liable” to disclose the correct answer.
  • Too much effort to document – for every lease the discount rate must be adjusted; options and guarantees must be reviewed constantly.
  • The effort to segregate the costs of servicing the space (operating costs) and using the space (lease costs) is time consuming and ambiguous in some gross and modified gross leases.
  • The incremental borrowing rate may be difficult to determine as most banks do not provide 100% financing or offer fixed interest rates and level payments. Investors will have a hard time using their traditional analysis to approve a real estate investment, especially as many tenants will be looking at leases with a shorter term.
The lease accounting changes create new operational challenges and a myriad of decisions related to increased leverage and profitability ratios in both a leased or owned real estate portfolio. Instead of cost per square foot, CFOs will begin to apply ratios related to utilization and return on assets. In the long run, the impact of these changes is less overwhelming than at first glance for three reasons. First, the changes are global. An increase in leverage due to FASB/IASB changes is less important to analysts when this increase is happening across the board in an industry. Second, the value of the underlying asset is not changing, but merely the way it is being measured is changing. Third, the business plan still drives the overall decision process. Leases can still provide a strong financing alternative and give business units flexibility. Although shorter lease terms may be more desired, leases will still need at least enough term to amortize tenant improvements.

Bill Early has spent thirteen years supporting commercial real estate managers with multiple facilities and has negotiated real estate transactions throughout the United States and Canada. Bill has drafted corporate real estate policy for national and global clients. Give Bill a call to learn what he can do for you.  Bill can be reached at 816-701-5000.