Big Changes Loom in New Accounting Rules

NEW YORK CITY-Contained in the “exposure draft” released this past Thursday by the International Accounting Standards Board and the Federal Accounting Standards Board is what Ernst & Young terms “a sea change” for the commercial real estate industry. While the harmonized IASB/FASB rules aren’t likely to take effect until at least 2013 and the ED is likely to undergo some revisions as it’s discussed here and abroad, the new and more complex leasing model it proposes is here to stay, says E&Y.

This new model eliminates the requirement to classify a lease as either operating or finance. Instead, all leases will now be recorded on balance sheets by lessees, who will be required to list both a “right of use” asset and a “future lease payment” liability.

Real estate companies that report under US GAAP guidelines will be required to adopt either the “performance obligation approach” or the “derecognition” approach. With the former, the landlord records a lease receivable and an equivalent liability representing the lessee’s use of the underlying property; under the derecognition approach, the owner has to split its investment property between a lease receivable asset and the residual value of the property.

In a GlobeSt.com column in July, Howard Roth, global real estate leader and a partner with E&Y’s real estate practice, noted that “Since the proposed revision of standards is expected to address the treatment of leases by both landlords and tenants, critics of the proposed accounting changes have commented that it could have the potential to change the way both parties approach lease transactions in the future.”

For example, Roth wrote, it’s possible that tenants with good access to capital “may decide to purchase their premises and therefore benefit from any potential future appreciation and the tax benefits of depreciation since the lease itself would be recorded on the balance sheet. This could, for example, result in the transformation of more multitenant office buildings to office condos.”

Alternately, wrote Roth, tenants that aren’t in a position to buy their real estate “may make the strategic decision to seek shorter-term leases, or not include extension options, to reduce the proposed lease model’s effect on their balance sheets. This, in turn, may lead landlords to seek higher lease payments to cover the perceived non-renewal risk of shorter-term leases.” Moreover, E&Y says, the possibility of shorter-term leases could affect valuations.

Other areas that could be affected by the new lease accounting rules include earnings measures and debt covenants, says E&Y. Given the new standards’ possible adverse impact on debt covenants, E&Y predicts that companies will have to negotiate amendments to lease agreements to consider the new leasing model, and may hesitate to approach lenders with such a request in the current credit environment.

Roth noted the potential effect on “the processes and technology used to calculate, monitor and record leases.” The new leasing model will require “significant assumptions,” including the probability of exercising extension options and contingent rentals, E&Y says. “Companies will be required to develop processes and controls for identifying such assumptions, which may increase the time involved in the reporting process.”