What is the fundamental issue with lease accounting regulations?
In February 2016, the Financial Accounting Standards Board (FASB) released its long awaited updated lease accounting standards. The Accounting Standards Update (ASU) on leases will take effect for public companies for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. For all other organizations, the ASU on leases will take effect for fiscal years beginning after December 15, 2019, and for interim periods within fiscal years beginning after December 15, 2020.
Under the new standard, companies are required to use a “right-of-use” accounting model where both lessees (renters) and lessors (property owners) recognize assets and liabilities arising from lease contracts. The FASB believes these changes will improve transparency as well as provide investors with more consistent and concise financial reporting.
In addition, FASB and the U.S. Securities and Exchange Commission (SEC) are working on implementing the Current Expected Credit Losses (CECL) accounting standard, which focuses on estimating expected losses over the life of a loan, using historical data, current conditions, and reasonable forecasts. The CECL standard will go into effect in January 2020 for some lending institutions. The standard currently in use relies on incurred losses.
I am a real estate professional. How do lease accounting regulations affect my business?
The new lease accounting standard may harm some businesses, especially lessees and lessors of commercial real estate. With leases included on balance sheets, some companies may see their debt-to-equity ratios increase and find it more difficult to obtain credit. The new standard may also complicate compliance with debt covenants or agreements between the bank and borrower. By capitalizing new and/or existing leases, some businesses could show more debt than allowed in their agreement with the lender, and therefore be in default of their loan. This could force some firms to put up more capital for existing loans or even have their credit lines revoked.
Additionally, the elimination of off-balance-sheet financing could be detrimental to commercial property owners. More frugal lessees will want less space and shorter-term leases without renewal options or contingent rents, which will decrease cash flow for property owners. Shorter-term rents will likely reduce the borrowing capacity of many commercial real estate lessors, who rely on leases and the value of the property as collateral in order to obtain financing. Ultimately, property owners would be forced to increase rent rates due to market uncertainty and reduce tenant improvements due to shorter recovery periods. Conversely, this change could encourage some firms to consider buying instead of leasing commercial real estate.
The CECL standards may have the effect of requiring that banks hold more capital as "counter cyclical reserves," which may impact their ability to lend - especially smaller lending institutions.
NAR Policy on Lease Accounting
NAR believes the new lease accounting standard will be detrimental to our nation’s economy. Also, NAR is opposed to lease accounting standards changes that would treat the income producing real estate business as a financing business on company balance sheets. NAR supported proposals that would have exempted privately held companies from complying with the new standard.
The new lease accounting proposal reduces the overall borrowing capacity of many commercial real estate lessees and lessors, by requiring them to recognize leases on their balance sheets as liabilities and assets, as opposed to their current treatment as operating expenses, which are not reflected on balance sheets. Including leases on balance sheets may have the effect of “bloating” them, and some companies may see their debt-to-equity ratios increase as a result, making it more difficult for them to get credit. Treating income producing real estate business as a financing business on company balance sheets will not accurately depict the unique characteristics of the investment real estate sector and in turn discounts the usefulness of the industry’s financial statements.
Legislative/Regulatory Status/Outlook on Lease Accounting
FASB released the new standard in late February 2016. The Accounting Standards Update (ASU) on leases will take effect for public companies for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. For all other organizations, the ASU on leases will take effect for fiscal years beginning after December 15, 2019, and for interim periods within fiscal years beginning after December 15, 2020.
Though the new standards are not effective for all companies yet, many companies have already begun to implement them in order to be in full compliance by the required deadlines.
The CECL standards are set to go into effect in January 2020. NAR has joined in industry coalitions and is working with Congress to extend the implementation deadline, in order to get more data on the impact of the changes on lending institutions and capital availability.
Commercial Federal Policy Committee