You Cannot LOL At The New Accounting Standards

So much fuss about the iphone 6.

People waited in line for days to be the first on their block to own the new phone (or maybe to make a killing on resale). Not to mention “Bendgate”, the concern that the iphone was so large it was bending in people’s pockets.

I can see waiting in line for days for Mets playoff tickets, but that happens only once in a generation.

Was it really worth the wait? As Conan O’Brien observed “The new iphone 6 is expected to have a larger screen and a better operating system. The new iphone will be called ‘last year’s Samsung Galaxy’”

Not to be outdone, in commercial leasing we also hang on the latest trends and await exciting new developments that may change our world.

Drafts of the new standards for leases from the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) have been issued and the final standards could be issued fairly soon.

I know, yawn. The only thing more sleep inducing than a lawyer talking about commercial leasing is to throw in some accounting gobbledygook.

But the new standards, which would require that all leases be capitalized to provide greater transparency to users of financial statements, will have a huge impact on the leasing industry.

Currently, all leases are classified for accounting purposes as either operating leases or capital leases. For the most part, real estate leases are considered operating leases which do not have to be recorded on a company’s balance sheet (they are usually disclosed in “notes” to the financial statement).

Under the expected new rules, all leases (for real estate, automobiles, airplanes, equipment, etc.) will need to go on a company’s balance sheet, indicating the right to use the asset for a period of time, with a corresponding liability indicating the obligation to make rent payments.

Currently, the new rules do not provide for “grandfathering” of existing leases and option periods are included if there is a “significant economic incentive” to exercise such option. Leases with a maximum term of 12 months are excluded.

The impetus for all this change is transparency. There have been a number of well publicized incidents where companies had huge off-balance sheet liabilities that were not apparent to investors (think Enron).

As David Tweedie, former chairman of the IASB, said “One of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet”.

You might ask, do I need to care about this when I only have 5 months to get ready for the next season of Game of Thrones?

The answer is yes. Some estimate that U.S. public companies alone will be adding $1.1 Trillion of existing real estate operating leases to their balance sheet. Yes, Dr. Evil, that was Trillion.

If you work for a company that follows Generally Accepted Accounting Principles (GAAP) (basically all public companies) or International Financial Reporting Standards (IFRS), or service such a company as your client, or intend to do business with such a company, you should care since the financial divisions and auditors of that company are going to care greatly.

Consider these four preparation suggestions from a tenant’s perspective regarding the new accounting standards:

• Stay abreast of ongoing developments. The standards have been revised over time as industry lobbyists and companies have pushed for amendments to ameliorate the harsher terms. The final standards will undoubtedly differ.​
• Interface early with your finance group. Adding real estate leases can have a significant impact on your company’s balance sheet, greatly affecting your financial ratios (and thus borrowing rates and cash flow) and your debt covenants. Get your CFO, finance group and auditors involved early in the leasing process, with respect to both new leases and examining the impact of the new rules on existing leases. These are players that have had a limited (or nonexistent) role in your lease negotiations in the past, but that will no longer be the case.​
• Be proactive. It would be prudent to prepare with your CFO and finance division even before there is a lease in the works. Companies may consider one or more of the following:​

○​  Modifying debt covenants in advance that might be anticipated to cause issues during lease negotiations. A company’s perceived debt may increase substantially and it will be harder to either obtain covenant waivers later to avoid a default or to obtain flexibility from the landlord under the pressure of lease negotiations.​

○​  Focusing on lease management. Sophisticated lease management and IT systems may be needed to keep track of a company’s real estate and easily obtain and report required information. For example, under the new requirements a company may need to quickly calculate the present value of future rent payments, to track changes in portfolios (new leases, modifications, terminations, etc.) and to respond to auditor inquiries.​

○​  Reviewing the possibility of ownership for certain core assets, now that these will be balance sheet assets even if leased.​

○​  Considering the advantages of funding its own tenant improvements (which will be accounted for differently) if the company’s corporate cost of funds is superior to the rate charged by the landlord under the lease.​

○​  Limiting the effect on the company’s balance sheet with leases of shorter durations, although shorter leases have higher rent and reduced tenant incentives and provide less long term security for landlords.​

• Expect the unexpected. We have already experienced more focused involvement of finance groups and auditors in lease negotiations on some of our larger leases. With the uncertainty of the final standards and understandable trepidation in the market, auditors tend to be extremely conservative in their interpretations and it may take some time for companies to identify (and address with the landlord) issues that experienced leasing attorneys and brokers have not had to face before. For example, a lease’s commencement date triggers the recording of the asset, but under the new standards common activities prior to the commencement date (such as some tenant access and/or work) can be interpreted as acceleration of the commencement date.​

As they say in iphone slang, AFAIK, saying IDK or IDC regarding the new accounting standards is not an option since FASB CSWS and will leave you thinking “ZOMG, I am a N00B”. Better IMHO to prepare my BFFs and LOL. GTG.​

​iPhone Slang Glossary​