Dec. 15, 2018 is closer than it seems, especially for companies that haven’t gotten themselves prepared for the implementation of the Financial Accounting Standards Board’s new lease accounting rules, followed two weeks later by the International Accounting Standards Board’s updated standards. No leases will be grandfathered in, and therefore, says Avison Young’s Sean Moynihan, the time is now to begin analyzing the new rules’ impact on companies’ financial statements.
“The main point about the FASB changes is this: How you negotiate the financial terms and conditions of a real estate lease will impact the financial success of your company,” says Moynihan, an AY principal and author of a new white paper on the subject. “By getting proper advice, from an advisor, who deals with the lease on the front end before the lease is done, your firm can control the impacts to your balance sheet and income statement. Many companies will be scrambling to gather the necessary information in 2018 if they don’t start preparing now.”
As the white paper notes, the new lease accounting rules have wide-ranging implications for tenants globally. Lessors of real estate won’t feel much impact; AY notes that for the most part, the FASB and IASB are leaving in place a model similar to today’s lease accounting requirements. Income statement and balance sheet treatment is similar to the way that leases are currently accounted for.
It’s a different story for tenants. The new lease accounting standard creates significant changes to the presentation and measurement of the lease obligation on the financial statements of almost every company, AY says.
“Under the forthcoming lease accounting standards, a lease will create a right-of-use asset and a lease liability, to be placed onto the corporate balance sheet,” Moynihan says. “Under the FASB’s model, leases will be evaluated and categorized as either Finance (similar to capital leases today) or Operating (similar to operating leases today).
Under the IASB’s proposed model, all leases will be classified as a Finance lease,” he continues. “Under both models, leases will be capitalized onto a firm’s balance sheet, but with very different effects on shareholder equity, EBITDA and overall profitability.”
It wasn’t so many years ago that the enactment of new lease accounting standards kept receding into the future. Those days are over. “The deadline of January 2019 remains set,” Moynihan writes in his white paper.
“Public companies that have yet to turn their attention toward this issue should consider that they will have comparative reporting in their 2019 financial statements that would reflect 2017 and 2018, and the window is quickly closing for them to invest the time and resources required to understand and mitigate the impact of the new rules,” he continues. “Also, companies subject to SEC reporting requirements would be wise to remember that the SEC requires public companies to disclose the impact of new accounting standards that have been issued—but not yet adopted—before those rules go into effect.”
The white paper, which is aligned with Avison Young’s risk-mitigation strategy, recommends that companies’ top executives take three immediate actions:
- Identify the right team members, particularly finance and real estate specialists, to help the company make the transition to the new standards.
- Conduct a strategic evaluation of the existing lease portfolio, starting with the largest leases, and assess how they will be accounted for under the new rules. Assess the impact on EBITDA and other key financial ratios and evaluate whether there is any potential impact on loan covenants.
- Consider renegotiating leases now, even if they are not up for renewal, in order to mitigate some of the less favorable impacts that would otherwise occur. Throughout the negotiation process, work closely with the company’s tenant advisor to address areas of concern with an eye toward protecting financial statements.
“One of the key challenges for corporate decision-makers is that using discounted cash flow to compare, analyze and structure real estate leases, which has been the common practice for more than 30 years, does not provide enough information to make an informed business decision,” adds Moynihan. “Executives should take a much more active role in the negotiation process by consulting with their tenant advisor, auditor and colleagues in the finance department to ensure that the impact is fully understood—before a lease is signed.”