What effect will Capital Lease Accounting have on Tenants?

As if Tenants didn’t have enough things to worry about, soon they will have a new accounting regulation with which to comply. This is known as Capital Lease Accounting. This regulation will not affect leases per se, but it will mean that Tenants will need to recognize the rent obligation of their leases as liabilities on their Balance Sheets. That is a simplistic description of what will be required, but suffice it to say more calculations will be required and the Balance Sheet will change.

Some have questioned whether this is yet another another mean-spirited regulation of government. Yes, it is a regulation (sort of), but it is not the government. The instigator of this initiative is the Financial Accounting Standards Board (FASB). FASB is the U.S. organization that forumlates accounting standards domestically. Internationally there is sister organization known as IASB (International Accounting Standards Board) which forumulates accounting standards for the IFRS. Confused yet? Anyway, the international standards have long required that lease obligations be recognized on balance sheets. In the U.S., most leases merely required that the “straightline” rents be reflected on the Income Statement as an expense, but not captured as a liability on the Balance Sheet. Internationl pressures together with the Enron and Worldcom fiascos of the early ’90’s have changed that. Since 2006, FASB has been wrestling with how to implement a satisfactory solution to the problem of greater transparency and international consistency.

As drafts of the change were circulated for review, many business owners and executives worried that the reporting would unduly penalize companies because of the proposed application of the regulation. The concern was that lease obligations would be front-loaded due to the calculation. Business leaders argued that rent payments tend to be relatively flat or grow modestly over the term of lease. Front loading would would portray an unrealistic picture of the indebtedness. It turns out that with some arm twisting, both the FASB and IASB agreed. They carved out a modified approach for real estate leases. A decision was reached to allow most real estate leases to avoid the sqewed front end liability. The same is not true for equipment leases, but that is a different discussion.

So what’s next? The new rules will likely be put into effect in early 2013. There will be NO Grandfathering. Tenants will need to comply with the new standards in the year of implementation even if they are mid-term in an existing lease term. The impact will be greater for public companies; they will be further required to restate the prior two years to reflect the impact of the change as if it had happened previously.