What’s The Impact of Proposed Accounting Changes on Commercial Real Estate?

New accounting regulations may soon be enacted that could significantly impact commercial real estate businesses and professionals. Revenue recognition, fair value accounting and disclosure, receivables accounting and disclosures, and goodwill testing could be affected.

But the biggest impact will come from the new joint Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) project on leasing.

A number of accounting pronouncements implemented during the past 8 or 9 years have been a result of Enron and other corporate scandals, or the intended convergence of U.S. and international accounting standards. The leasing project is both.

Existing leasing rules have been criticized for omitting relevant information about rights, and, more importantly, obligations that may meet the criteria to be recorded as assets and liabilities. These new rules will cause these assets and liabilities to be recorded by the lessee in most situations.

No shortage of opinions

An exposure draft on the new rules issued in August 2010 received so many comments that it was withdrawn for changes and will be reintroduced. The FASB and IASB have had numerous meetings since the release of the exposure draft and have reached certain “tentative decisions” that significantly changed the rules as originally exposed.

This article presents a model that incorporates these tentative decisions through Dec.  23, 2011. The new exposure draft is expected to be released for comments in the first half of this year.

Under the existing rules, the lessee classifies leases as either operating or capital, depending on the terms. If classified as operating, the leasing costs are expensed as incurred and no asset or liability is recorded. Future commitments are only disclosed. If classified as capital, an asset and liability are recorded on the books. The lessor records leasing income or a sale, depending on the terms, and typically mirrors the treatment by the lessee.

The proposed new rules introduce more of a “right-of-use” model as opposed to an ownership model. This new model is similar to current capital lease accounting with some twists. Accordingly, there will be significant implications for both the lessee and the lessor in all areas of commercial real estate including, retail, industrial, warehouse and office.

A hypothetical example

Let’s suppose Landlord Co. leases facilities to Tenant Co. Tenant would record an asset (representing its right to use the leased facilities) and a liability (representing the present value of future lease payments). Tenant would amortize the asset over the shorter of the expected lease term, or the useful life, and record interest expense on the liability.

Landlord would record the transactions according to what is called a “receivable and residual approach.” In other words, Landlord would record an asset representing its right to receive lease payments (a receivable) and a “residual asset,” which is calculated as an allocation of the carrying value of the facilities between the portion related to the right-of-use granted to Tenant and the portion retained by Landlord.

Landlord would recognize profit on the “sale” of the facilities. Over the term of the lease, Landlord would recognize interest income on the right to receive payments and accretion income on the residual asset.

The way the rules are now, the landlord must record their facilities as an asset, depreciate their facilities, and record rental income as earned. Under the proposed rules, the landlord will record the right to receive payments and residuals as assets, profits will be recognized upon the transfer of right to use of their facilities, and interest and accretion income will be recorded over the life of the lease. As for the tenant, currently they must record rent expenses as they’re incurred. However, the proposed rules will lead the tenants to record right to use as an asset, future rent (discounted) as a liability, interest expense as a liability, and they will have to depreciate the asset as well.

As with any new rules, there are exceptions. Most notably, investment property entities and leases of 12 months or less could be exempted from these rules.

The proposed criteria used to define investment property entities are subject to significant judgment and interpretation. Hopefully, the criteria will be clarified as this and the FASB and IASB project on fair value progress.

Much at stake

Who will feel the biggest impact of these changes? Lessees would be most affected if they have a significant portfolio of assets held under operating leases, especially those with leases of property. These rules could impact debt covenants or other agreements, which limit capital improvements or incurring new debt.

Lessors that own a significant amount of rental real estate, and are not investment company entities, will be substantially affected as well. The face of their financial statements will drastically change, which could impact their ability to refinance or borrow.

Additionally, both the lessor and lessee will have complicated calculations and evaluations to perform at implementation of the new standards, upon entering into a new lease, and throughout the life of the lease.

Many questions still remain about all aspects of this project. We already know that the new exposure draft will be significantly different from the original.

Commercial real estate professionals should take the following steps:

• Start analyzing the potential impact of the new rules;
• Be proactive with your financial statement users;
• Monitor the progress of this leasing project and provide feedback to FASB;
• Stay in touch with your accounting professional.

Alan Chosed, CPA, is an Audit Principal with Miami-based Kaufman, Rossin & Co.