Accounting change could have huge impact on real estate leasing

December 11, 2010
A new accounting rule that proposes to change the way tenants book leases on their financial statements could have major implications for the commercial real estate industry.

The Financial Accounting Standards Board, which sets American standards, has been collaborating with the International Accounting Standards Board to merge its generally accepted accounting principles, or GAAP, with international standards.

One piece under consideration requires both American and foreign public companies to book leases as assets and liabilities on their balance sheets instead of merely listing them as footnotes.

As a result, a total of roughly $640 billion in leases will show up on balance sheets, according to FASB, which says the current method of reporting rental agreements “gives a false impression of companies’ liabilities and gearing.”

FASB accepted comments on the proposal until Dec. 15 and expects to complete the rule next year and enact it in 2012 or 2013.

Greg Arnott, regional accounting and auditing director at the Indianapolis office of Springfield, Mo.-based accounting firm BKD LLP, has been alerting clients to the coming change for the past year.

“A lot of people are not happy about it because they don’t want to reflect these liabilities on their books,” he said. “But from a cash-flow standpoint, it doesn’t really change anything.”

Renters and landlords typically structure leases to keep them off a balance sheet because most companies don’t like to report a lot of debt.

Inconsistencies in the way companies log leases and the need for uniformity between American and international standards, particularly since many public companies have overseas operations, led FASB to undertake the effort.

Once the rule takes effect, companies will record as a liability the cost of rent over the remaining term of the lease and record as an asset their right to use the space.

“If you think about a lease, it’s not much different than any other liability,” Arnott said. “So the accounting should be similar. You should record an asset for what you have and a liability for what you owe.”

Companies already struggling under heavy debt loads will be among those affected most by the new rule.

One consequence is that tenants may consider more seriously purchasing space rather than leasing. Among those most affected by the change will be large retailers with scores of leases.

Indianapolis-based HHGregg Inc. leases all of its 173 stores and distribution centers spread throughout 11 states, as well as its corporate headquarters on East 96th Street.

The appliance and electronics retailer is uncertain what impact the proposed rule will have on the publicly traded chain, said Andy Giesler, HHGregg’s vice president of finance.

“But we’re monitoring it very closely and waiting for the next release to come out,” he said.

So is Bill French, a retail specialist with Cassidy Turley.

Retailers undoubtedly are skittish about revealing financial details of their leases because, many contracts contain confidentiality agreements that keep rental terms and amounts private, French said.

An upside to the proposal, however, is that companies leasing space are considered to be buying the right to use that space for a certain amount of time. Not unlike a homeowner who begins with a large mortgage but reduces it as the principal is paid down, companies will record their rent as a liability at the start but will reduce the debt over the term of the lease.

Still, publicly traded retailers may have even deeper worries when attempting to attract potential investors who may avoid a stock because of the additional debt recorded under the new rule.

“If all of a sudden you have ‘X’ amount of lease obligations, people start looking at that and it makes them concerned,” he said. “I think disclosure can be good, but I think it’s going to be painful for some in the beginning.”

Any new rule requiring companies to report leases as assets and liabilities could prompt more to purchase property, French acknowledged. But retailers in particular choose to lease for a reason, because consumer demand can cause store formats and sizes to change dramatically within just a decade’s time.

Take Wal-Mart for instance, French said. When it entered Indiana in the mid-1980s, its stores averaged 60,000 square feet and grew to more than 200,000 square feet with the advent of the supercenter concept. The retailer a few years ago began ratcheting back store size to about 180,000 square feet.

Sinking $30 million into a large, big-box development makes little sense when the life of a store might be only 15 to 20 years, French said.

At any rate, several uncertainties to the rule remain, likely leading to more debate about the issue before it becomes standard practice.

Said French: “I don’t think we understand the full extent of how it will impact us and what the requirements will truly be.”•

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