New Accounting Standards Impact Balance Sheets and Other Considerations
In February of 2016, the United States and international accounting boards (the FASB and IASB) reached a consensus on changes to lease accounting rules under United States-Generally Accepted Accounting Principles (US-GAAP) and International Financial Reporting Standards (IFRS). Those changes, which go into effect later this year, will significantly alter how leases impact a company’s financial statements. While the accounting standards update (ASU) will impact all companies and organizations that lease assets, such as airplanes and manufacturing equipment, it notably includes commercial real estate as well.
Why the changes
According to FASB, the new guidance provide a more faithful representation of an organization’s leasing activities. “It ends what the US Securities and Exchange Commission and other stakeholders have identified as one of the largest forms of off-balance sheet accounting, while requiring more disclosures related to leasing transactions,” says FASB Chair Russell G Golden. Golden notes that ASU considered the input of preparers, auditors, and other practitioners, and says that their feedback was instrumental in the creation of the new standard.
Leases must now appear on corporate balance sheets
Under the new guidance, organizations that lease assets—referred to as “lessees”— are required to recognize on their balance sheet the assets and liabilities for the rights and obligations created by those leases. The ASU applies to all leases with a term of more than 12 months.
Consistent with current GAAP, the recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee primarily will depend on its classification as a finance or operating lease. However, unlike current GAAP—which requires only capital leases to be recognized on the balance sheet—the new ASU will require both types of leases to be recognized on the balance sheet. This is a change from the past where some leases often only appeared as footnotes on investor filings. That means businesses will now record leases as “other liabilities”, causing reductions in equity and shifts in debt-to-equity ratios.
The ASU also will require more comprehensive disclosures to help investors and other financial statement users better understand the amount, timing, and uncertainty of cash flows arising from leases.
Property owners largely unaffected
The accounting by organizations that own the assets leased by the lessee—also known as lessor accounting—will remain largely unchanged from current GAAP. However, the ASU contains some targeted improvements that are intended to align, where necessary, lessor accounting with the lessee accounting model and with the updated revenue recognition guidance issued in 2014.
While the obligations for property owners remain largely unaffected, lessors may see a shift in tenant behavior. Since leases will now be recorded as “other liabilities” as opposed to straight debt, this makes buying and leasing appear very similarly on the balance sheet. This may encourage lessees to reconsider leasing versus buying the space. According to a blog post by Cornell University, co-working companies (a company that subleases “space” to a sub-tenant) and retail anchors are two types of organizations that may lean toward buying. Under the new accounting rules, long-term leases may become less appealing as the lease liability may be greater than the value of the property.
FASB set on moving forward
Both landlords and tenants will have a lot to consider surrounding the new ASU. Only time will reveal the impacts on commercial real estate, and there will likely be some growing pains. It is important to note, however, that while some companies have expressed concern about the new standard and have said the timeline is too quick, the FASB is steadfast that the changes will go into effect as scheduled. To meet that timeline, businesses should already be working with their accounting and finance professionals for help with implementing the new standards.