Remember Enron and off-balance-sheet accounting scandals? The efforts to clean up these accounting practices are still in the works and are about to hit the world of commercial real estate—arguably at the worst possible time. The Financial Accounting Standards Board (FASB) (which is endowed with the power to decide U.S. generally accepted accounting principles) and its international counterpart, the International Accounting Standards Board (IASB) are hoping to enact a new lease accounting standard by 2013. The Securities and Exchange Commission in a 2005 report to Congress estimated that the current lease accounting standards which went into effect in 1976 allow tenants to keep about $1.25 trillion in future liabilities off-balance-sheet.
Currently, a lease may be shown on a tenant’s balance sheet as either a capital lease which is treated on the balance sheet much like a finance transaction or as an operating lease which is mostly off-balance sheet. The FASB and IASB believe that investors are not getting a full picture of a tenant’s obligations when the lease is treated as an operating lease because the lease payments are recognized as an expense when they are incurred or paid rather than all of the rental payments for the term appearing as a liability on the balance sheet.
One solution the FASB and IASB could have chosen (but did not) would be to treat all leases as capital leases for accounting purposes. Instead, the FASB and IASB decided that all leases are to be treated as capital leases, PLUS, tenants will now have to include in their liabilities not only the rent for the current term which the tenant is contractually obligated to pay, but will also include on the balance sheet contingent liabilities “that are more likely than not to occur”. It is the inclusion of these contingent liabilities that are the most controversial in the proposed changes.
Tenants argue that deciding which extension terms are more likely than not to occur is guess work. Further, placing extension terms on the balance sheet does not accurately reflex liabilities because the tenant has flexibility in whether or not to exercise the extension option and the rents are not a legal obligation unless and until the extension option is exercised. Thus, the liabilities will be artificially inflated to comply with the new standards. The International Council of Shopping Centers (ICSC) is requesting that the agencies provide a special exemption for shopping center leases and certain short term leases.
Patricia McConnell, a board member of the IASB notes that not including extension terms and contingent rents (e.g. percentage rents or overage rents) could result in some funny leases meant to keep the leverage shown on the balance sheet low: “The lease could be structured with a very short initial term but with many, many renewal options and/or a very small contractual rents but large, virtually guarantees contingent rents.”
There is no grandfathering, so leases existing as of the effective date will have to go on the balance sheet just like new leases. Tenants signing new leases should consider the effect of the new standards on their balance sheets and may wish to consider shorter lease terms. Rather than providing for an option to renew the lease, the tenant may negotiate a right of first refusal or right of first offer to lease the premises after the initial term. Further, some tenants may desire to purchase their real estate rather than continuing to lease since the balance sheet benefits will disappear when the new standards are enacted.