The upcoming FASB accounting changes are not only a challenge for corporate accounting teams, but also for the commercial real estate group. To get you up to speed, here’s an executive summary of the new lease accounting standards (both U.S. and international) with a focus on the business risks involved.
FASB accounting: a primer for CRE executives
When do the IFRS and FASB accounting changes take effect?
Both the new lease standard from the U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) released their respective new leasing standards in the first quarter of 2016.
The US standard, ASU 2016-02, is effective for public business entities for annual periods beginning after December 15, 2018. The International standard (IFRS 16) takes effect in January 2019.
What’s changing and why?
The essence of the two standards requires that leases are to be put on the balance sheet as “Right of Use” (ROU) assets, and corresponding liabilities. That’s a big change for commercial real estate accounting. And it’s not only accounting for real estate that’s changing: the new FASB accounting rules also impact equipment and asset leases.
The purpose of the IFRS and FASB accounting change is to be provide greater transparency in a company’s leverage since leasing is in essence a form of financing.
How are the IFRS and FASB accounting changes different?
Perhaps the greatest difference between the US standard and the International standard is the question of finance leases versus operating leases.
The FASB decided to maintain two methodologies, one for operating leases, and one accounting for financing or capital leases. The IASB opted to classify all leases as financing leases. The FASB argued that there was a need to differentiate between the two types of leases to maintain a level of simplicity since most leases wouldn’t meet the criteria for a capital lease.
Under the new FASB accounting rules, the four criteria for a capital lease are:
- The lease automatically transfers ownership of the property to the lessee by the end of the lease.
- The lease contains a bargain purchase option.
- The lease term equals 75% or more of the estimated economic life of the property.
- The present value of the minimum lease payments at the beginning of the lease term equals or exceeds 90% of the fair market value of the property.
Conversely, the IASB opted to classify all leases as financing leases, again arguing for simplicity.
IFRS and FASB accounting changes: Understanding the risks
With the release of new leasing standards by both the FASB (Financial Accounting Standards Board) and the IASB (International Accounting Standards Board) CRE executives face one of the most daunting challenges in recent memory that will impose considerable legal and operational risks on public companies.
Missing the IFRS / FASB accounting compliance deadline
Perhaps the biggest risk with the new leasing standards will be missing the effective dates. If you aren’t well along with the implementation process, you’re already late. The new standards require that public companies put all leases of more than one year on the balance sheet as “value in use” assets and corresponding liabilities. It’s been estimated that the new standards will result in over $1.2 Trillion in incremental assets and liabilities on worldwide balance sheets.
The Financial Accounting Standards Board (FASB) new lease standard will take effect for fiscal years, and interim periods within those fiscal years, beginning December 15, 2018 primarily for public business entities. The effective date for the International Accounting Standards Board (IASB) will be January 1, 2019. Most commentators estimate that it will take at least a year or more to complete the transition to the new leasing standards.
For companies with centralized real estate organizations and centralized lease data bases, implementation of the FASB accounting changes will be tedious but relatively straight forward. But many companies have their leases scattered through their divisions which could well extend the time to convert by several months, maybe years. Getting all lease data into one unified database will be the priority, and then updating your lease administration software to complete the necessary calculations will be the next step.
Certain industries which primarily lease their operating assets will be challenged to meet the deadlines. This would include retailers with large portfolios of stores, airlines with vast fleets of leased aircraft, and shipping companies, with large fleets of leased water craft. With the explosion of cloud computing, IT assets have been growing exponentially, and most of these servers and main frames are leased.
CRE managers will be well advised to coordinate closely with external auditors on the update and transition process. Failing to convert could result in a violation of the Sarbanes Oxley (SOX) regulations which could result in sizable fines, and possible prosecutions, with all the bad publicity that would come with an SEC violation.
Lacking the resources and expertise to implement the FASB accounting changes
Chances are you will not have sufficient manpower or expertise to collect the data you need to convert to the new FASB accounting standards. An immediate priority will be to assess staffing levels and recruit the necessary manpower to complete all tasks of conversion.
It may make sense to contract with consulting firms that have the necessary expertise and manpower to get the job done. While more expensive, this approach assures that conversion meets deadlines with full compliance.
Impact of the FASB accounting changes on loan covenants
Other risks that will come with the new standards will be possible violations of loan covenants. By substantially increasing the liability side of the balance sheet, could affect allowable debt levels in various corporate financing contracts. Coordinating with your company’s key lenders will be a priority action item.
What other changes can you expect as a result of the new FASB accounting standards?
In one of my early blog posts in 2015, I characterized the coming leasing standards as a “Tsunami” in that the changes would sweep across corporate portfolios like a monstrous wave, causing havoc with corporate accounting, leasing strategy, and balance sheet reporting. Like any major change to rules and standards long embedded in corporate accounting, the impact to corporate leasing practices will be forever changed.
How these changes will affect real estate markets, corporate real estate ownership, leasing demand, and other related factors is up for speculation. One thing’s for sure. CRE managers will be held accountable for the successful transition to the new standards. With only months left, time is of essence.