Investors and other users of financial statements consistently grapple with respect to differences in accounting principles and the associated impact both from a balance sheet and income statement perspective. Oftentimes, a significant amount of analytical due diligence is required to compare and contrast the financial performance of a business with other companies operating in the same industry. One area of significant disparity relates to the accounting treatment associated with real property leases. Differences in this regard are especially magnified when comparing U.S. GAAP reporting to International Accounting Standards. The convergence of the standards has remained a significant hot topic with respect to financial reporting issues and the respective standard setters have implemented changes over time which has reduced differences in accounting requirements. One proposed “game changer” in this regard pertains to a joint effort between U.S. standard setters and their respective international counterparts to dramatically alter the accounting requirements associated with lease accounting. Given the magnitude of real property from an expense structure standpoint this article highlights various issues associated with this asset class specifically.
The following table illustrates some of the major disparities between current U.S. GAAP and international financial reporting standards:
The proposed changes would essentially overhaul the standard set of rules pertaining to financial lease accounting, also known as ASC Topic 840 (formerly known as Financial Accounting Standard 13). Though not officially finalized at this time, the major changes pertain to: (i) eliminating all operating leases and applying accounting treatment for leases generally consistent with that of capital leases; and (ii) include a “Right of Use” asset on the left hand side of the balance sheet and the obligation to pay rent as a liability on the right hand side of the balance sheet.
These proposed changes will result in a very material impact on the financial statements of many businesses. It is obviously critical that preparers of financial statements understand the proposed changes but also that management is informed and considers the accounting and financial consequences of decisions regarding renewing and entering into real property leases. The following highlights some of the more material aspects to consider.
Earnings Before Interest, Taxes, Depreciation, and Amortization (“EBITDA”) Will Increase
As indicated, the proposed changes would eliminate all operating leases. In that regard, rent expense will no longer be recorded in any circumstance and instead depreciation and interest expense will be separately reported. Considering that the majority of leases in the U.S. are currently recognized as operating leases, this will unquestionably have a substantial impact on financial records and will result in an immediate increase to EBITDA. To further illustrate, consider the example in Chart 2.
As illustrated, holding everything constant, EBITDA will increase in the near-term given the elimination of rent expense. However, net income will decrease and by a greater magnitude based on the term of the contract. Over the full term of the lease, the total cash flow impact is the same under both standards, assuming no changes in inflation or interest rates.
The Negotiated Lease Term Will Have a Significant Impact on Reported Net Income
Under the proposed regulations, the length of the lease term will have a significant impact on the amount of expense recorded over time. In fact, a shorter lease term will typically result in higher earnings per share as compared to a longer lease term (as longer-term leases become more expensive in early years, resulting in more “debt” added to balance sheets and causing net income to decline). As a result, management should carefully consider lease term and also the impact relating to renewal options when structuring transactions. To further illustrate, consider the following example in Chart 3 and 4 (again, the examples assume no changes in interest rates or inflation):
Balance Sheet will be Dramatically Impacted
Under the proposed regulations, the balance sheet will be dramatically impacted. On the left hand side of the balance sheet, a “Right of Use” asset will be capitalized and will be depreciated over time. Correspondingly, the right hand side of the balance sheet will include an obligation to pay rent which will be reduced as rental payments are made. This will dramatically impact financial ratios and thus should be scrutinized closely as it pertains to debt covenants and other areas surrounding financial performance metrics. To further illustrate, consider the following example in Chart 5.
Given the balance sheet impact, the SEC has estimated that the change in accounting policy could add upwards of $1 trillion to balance sheets upon implementation. The resulting impact as illustrated in the table below is that a huge amount of “debt” will now be reflected on the balance sheet as an “obligation to pay rent.” Given the material impact to the balance sheet, it is critical that management consider and plan for the impact from a financial ratio perspective relating to debt covenants associated with existing and future loan agreements.
It is important to note that these proposed changes will not be subject to grandfathering. As of the effective date (which is yet to be determined) all leases will be reclassified from that point forward. These proposed changes continue to be hotly contested and debated. However, it is probable that they will be adopted in some fashion. Due to the anticipated impact, it is important that accounting, finance, and real property corporate professionals work in tandem on current and future real property investment decisions.
