TRIRIGA Insights

March 2009, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued a joint discussion paper highlighting proposed changes to financial accounting standards for leases (FAS 13) which governs the accounting treatment of operating leases. The FAS 13 changes outlined could have an enormous impact on the balance sheets and income statements of companies with significant operating lease obligations.

Today, FAS 13 requires that operating leases are classified as an off-balance sheet transaction and only the current year operating lease expense is accounted for in the income statement. Corporations must also include a note in their Security and Exchange Commission 10-Q and 10-K filings detailing the anticipated rent expense for the next five years. Proponents for changing the FAS 13 rule argue that the current standards fail to give an accurate view of a company’s liabilities. This argument seems valid given the fact that operating leases represent the single largest source of off-balance sheet financing for most organizations. Furthermore, for many organizations, operating lease obligations represent a larger liability than all other liabilities on the balance sheet combined. For this reason, the FASB has spent decades debating the proper accounting treatment of operating leases.

Highlight of proposed changes to FAS 13
The FAS 13 changes proposed in the March discussion paper would require that all operating leases be reclassified as capital leases. Capital leases differ from operating leases in that they must be recorded on the balance sheet and are treated as a financing transaction on the income statement. The right to use the leased property would be capitalized as an asset and the present value of future lease payments would be accounted for as a liability. Rent payments would no longer be included in EBITDA (Earnings Before Interest Taxes Depreciation and Amortization). Instead, a before tax depreciation and interest amount would be calculated to account for the annualized use of the property. For a more in depth summary of the proposed changes read “FAS-Talking: Unpacking Real Estate’s Impact on Financial Statements” in the September 2009 issue of the CoreNet Leader magazine.

The proposed changes are currently being reviewed by FASB, IASB, and others. The next draft of the new lease accounting standards should be available later this year and the final rule could be put in place as early as 2011.

Impact of FAS 13 change to financial statements
There is little doubt that the proposed FAS 13 lease accounting changes would have an enormous impact on financial statements. Simply moving operating leases onto the balance sheet would add over one trillion dollars to the balance sheet of U.S. companies. The income statement changes would have a positive effect on EBITDA due to removal of rent expense from operating expenses. However, the additional depreciation and interest expense required by the proposed FAS 13 changes would result in an overall decrease to net income during the first half of the lease term.

For companies that control most of their real estate through operating leases, the proposed lease accounting change will have a significant effect on financial statements. Balance sheet and income statement changes have the potential to adversely affect debt covenants and performance ratios. All else being equal, financial metrics such as the debt-to-equity ratio and interest coverage ratio could increase significantly. There is much debate about the effect this will actually have on a company’s valuation and cost of capital since many investors and financial institutions already factor in operating leases into financial analysis. Regardless, companies who are affected by the proposed FAS 13 accounting change will need to thoroughly predict and explain upcoming changes to financial statements.

Impact of FAS 13 change on strategic real estate decisions
It is important to keep in mind that the proposed FAS 13 lease accounting changes do not have a direct effect on cash flow; arguably the most important indicator of financial performance. However, companies will need to invest time and money to evaluate lease structures, determine the impact to financial statements, and communicate the impact to investors well in advance. Although this exercise is critical, real estate executives and professionals must not lose focus on the primary goal to align real estate assets with the business strategy. Although the proposed FAS 13 rule change may alter the buy versus lease decision or add a new variable to lease negotiations, accounting rules are seldom a primary driver of real estate decisions. The proposed FAS 13 changes illustrate the fact that, more than ever, real estate executives and professionals require a decision support system that provides the ability to prioritize objectives and make tactical decisions that align with the business strategy.