Do you have a sense for the magnitude of changes being discussed by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) related to lease accounting?
It will have an unprecedented, one-time impact on your balance sheet by creating a tremendous increase in assets, representing the right to use real estate property, and a corresponding increase in liabilities, representing the commitment over the lease term to pay for the right to use.
When discussions conclude with the final ruling in 2015, FASB is expected to release changes required to implement lease accounting for two different types of leases. During this period of uncertainty, there are several action items managers can be doing now to prepare themselves and their company.
Financial Reporting Impact
In the new proposal, leases that are currently classified as operating leases will no longer be reported in the financial footnotes. Leases will be reported on the balance sheet as both an asset and a liability to better report the financial impact and commitment they represent. The asset represents the rights the tenant has to use the asset (right-of-use asset). To enjoy the right of use, the tenant must make payments to the lessor. This obligation is recorded in the books as a liability. To determine the value of the asset and the liability, you must total all of the expenses of the lease, less non-executory costs such as insurance and utilities. Future cash flows should be discounted to arrive at a Present Value (PV), to allow for the idea that money available today is worth more than the same amount in the future.
Anticipated Financial Effect
To get a feel for the impact to your financial reporting, calculate a present value of the current lease obligations in your portfolio. As a general rule, only include accounts that are rent accounts. Use the current incremental borrowing rate for your company to discount future cash flows; this is your imputed interest rate. The PV (Present Value) that results will approximate the increase to total assets.
Lease administration will become more intensive and will require more effort to compile the required data and more judgement to make decisions required to implement the new standard consistently for every lease. Lease administrators will need to record the following data during the abstracting process:
- Direct costs or expenses incurred to acquire the lease which will be set up as part of the asset in the initial recognition.
- Lease options such as renewal, automatic renewal, termination, purchase and the financial implications.
- Other lease stipulations which might create additional expenses, such as residual value guarantee expenses.
The real estate department will also be closely involved with the financial restating effort needed to adjust prior financial reports to the new standard for comparison purposes. With many non-real estate leases having been obtained locally and regionally, it may be a large undertaking to think about processing them differently to ensure that there is a central ability to report on all of them with the new standard. Further complicating this is the need to restate your financial statements. Although most of these leases have not been on the balance sheet historically, it will be a significant amount of work to inventory all of them as of several key dates, restate the way that they had been accounted for and then record them utilizing the new directive.
Due to their size, real estate leases will be particularly affected by the new standards. The accounting changes will underscore the strategic impact and value of real estate to the overall company, as well as showcase your ability to manage change and lead the way by reaching out to other parts of the organization that are affected. We will know more as the Boards continue to update us on their deliberation efforts. Until then, now is the time to seize the initiative and commit to a proactive approach to the challenge. Rest assured that CoStar Real Estate Manager is your watchdog for this topic as we all progress together toward learning what the final determination will be.
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