Lease Accounting Overhaul – Now is the Time to Prepare

January 2016
Tyler Hales

leaseaccounting5 Strategic Considerations- 

Last month the Financial Accounting Standards Board (FASB) voted to proceed with a new lease accounting standard. Much has been written about the new Lease Accounting Standard – at least one report indicates that the balance sheet impact of the new guidance for U.S. companies is as high as $2 trillion. In addition, the FASB received more than 1,700 comment letters on the exposure drafts of the standard and held more than 200 meetings with financial statement preparers, users, practitioners, and standard setters. Clearly, this is a topic that garners strong opinions from many wide and varied interested parties. While, it’s been a mundane subject for years, the time is near and we’re advising clients to prepare now. In fact, R. Harold Schroeder, an FASB Board Member, recently advised, “If you want to get something changed in the system for 2018 or ‘19, you’re already late in terms of…working with [information technology] systems to get it changed.”

This new guidance will require companies to report all leases with terms more than one year on the balance sheet as both a Liability and offsetting “Right of Use” Asset. Previously the only required disclosure for these obligations was in the footnotes to the financial statements. This change requires companies to account for leases as if the asset was purchased. While property is not actually purchased in a lease, the intent behind the new rule is to capture the acquisition of the right to use the asset for the lease term. This change will impact a number of financial ratios and will increase the assets/liabilities most companies report on their financial statements.

The final standard is expected to be published in early 2016 and will be effective for fiscal years commencing after December 15, 2018 for public companies (one year later for private companies. While countless white papers and status updates have been written regarding this new standard, these haven’t addressed some of the key strategic considerations to help your company prepare for this change. Here are 5 considerations to help you with this change:

  1. Create a transition plan. While the final standard is not yet released, most details are known. There is no need to defer creating a plan to transition to the new standard. It is critically important to begin working with key stakeholders on a project plan to implement the transition. Carefully consider who should be included in these plans – the in-house real estate and accounting teams, IT, external auditors, and corporate real estate firm. It is also important to note while the new standard isn’t effective for a few more years, disclosure of comparative financial statements is required under Generally Accepted Accounting Principles (2 years for balance sheet and 3 years for income statement). In other words, when the new rules are effective, previous years’ financials will need to be presented in accordance with the change so the time to start preparing is now.
  1. Consider required system changes and migration to lease administration software. In the past, recording journal entries for leases based on calculations in excel spreadsheets may have been enough. Given the complexity of the new guidance, we recommend the implementation of a lease administration/accounting system. In selecting software, carefully consider to the functionality, compliance with current and future accounting guidelines, ability to interface with current accounting program. The IT team should be involved early to assist with the controls environment, change management, and testing of reports used from the new system.
  1. Thoroughly understand the financial impact on your Company. Any company with one or more leases will report an increase in both assets and liabilities as a result of the change. Despite this, most ratios/measures that analysts and creditors are focused on will remain unchanged including EBITDA, gross margin, operating expense ratio, current ratio, and debt to equity ratio. Further, because the lease liability will not be classified as debt, most debt covenants should be unaffected. Of course, it is wise to review your Company’s debt covenants to be sure. While most ratios are unaffected, the quick ratio and return on assets will be impacted negatively due to the increase in liabilities and assets, respectively. It is important to remember that credit rating agencies, lenders, and analysts factored operating leases into their analyses even prior to the accounting change. Accordingly, the new standard is not likely to significantly impact their view of a company. All companies’ impacted ratios will move in the same direction – to the extent that impacted ratios such as return on assets are used for measuring performance, these should be adjusted to account for the change.
  1. Consider how the new standard will impact lease negotiations. Once the new standard is in place, Companies will be motivated to negotiate leases to allow them to capitalize the lowest amount possible. Accordingly, it is important to determine which costs to include in the capitalization calculation and which costs are not included. Here are a few examples of such considerations:
  • Renewal options – current guidelines indicate that companies must capitalize rent from the renewal period if a company is “likely” to exercise the renewal option. This means that if there is a strong economic incentive to renew (e.g. renewal option is below market rate or the space is so specialized that it would cost an exorbitant amount to relocate) then the rent from the renewal period would be included in the capitalized asset/liability.
  • Rent escalations – fixed dollar or percentage increases need to be included in the capitalized amount while increases tied to CPI escalations will not be included in the initial lease liability/asset.
  • Service portion of rent – current guidelines state that companies will be able to exclude from the capitalized amount any portion of rent that the company is receiving a service for. This includes the operating base amount in a gross lease and utilities/electricity in a full service lease. If there are other services (e.g. gym use), these may need to be bifricuated from the rent in the lease negotiation to ensure that they can be deducted from the capitalized amount.

While the market will adjust to the accounting change, lessees will also react and modifying lease strategies and terms where they can.

  1. Make the right business decision first, then deal with accounting impact. This accounting change will not impact the financial strength, valuation, or credit rating of a company. It is important to make the right decision for your business first then use a thorough understanding the the new guidance to help structure the deal in the most beneficial manner possible.

At T3 Advisors, we strive to make changes like this as easy as possible for our clients. We want to be there every step of the way to assist you in creating a transition plan, determining the optimal software and system changes, and advising you on structuring real estate transactions in the most favorable way for your company. Feel free to reach out to me directly at tyler@t3advisors.com to discuss anytime.

About T3 Advisors

T3 Advisors provides real estate and workplace solutions for the world’s most innovative companies that range from 2–10,000 employees. By acting as an extension of the team and only representing tenants, T3 offers transparent, conflict-free real estate strategies.

T3’s services include tenant brokerage, location advisory, portfolio planning, consultative insights, project management, and workplace strategy. Placed at the center of innovation ecosystems with offices in San Francisco, Palo Alto, New York City, and Boston, T3 has advised thousands of companies globally, including LinkedIn, HubSpot, Postmates, ASICS, AutoDesk, and Battery Ventures.