Real Estate Impact Huge Under Accounting Changes

I first heard about the proposed changes in accounting for leases last spring when the ICSC picked up on the issue from the on-going discussions between FASB who is sets the accounting standards and the International Accounting Standards Board to create a uniform accounting standard around the world. CB Richard Ellis has published a report on the potential impact of the change in accounting. Globe St. published a special report summarizing this study which is below. The full report can be accessed at: http://www.cbre.com/NR/rdonlyres/8D7AEFC0-1154-472A-8521-6323B02AE3A6/777874/FAStalkingCBRE082009.pdf

By Bob Howard GlobeSt.com EXCLUSIVE Last updated: October 1, 2009 10:05am
LOS ANGELES-New accounting standards requiring property to be marked to market and proposed changes in lease accounting rules could have an immense impact on the balance sheets, income statements and overall financial outlook of US corporations, many of whom are unprepared for the changes, according to a new report from CB Richard Ellis.

The white paper by CBRE, titled "FAS Talking--Unpacking Real Estate's Impact on Financial Statements," says that the estimated balance sheet impact of the proposed lease accounting changes alone could be well in excess of $1 trillion for US companies. The report says that the combined effects of mark-to-market and the lease accounting changes hold the potential to negatively impact earnings, capital requirements, debt covenant ratios, credit ratings and other measurements of corporate financial health.

Todd P. Anderson, CBRE senior managing director of global corporate services who co-authored the report along with CFO Michael M. Omiya of Boeing Realty Corp., explains to GlobeSt.com that the changes in accounting standards are "a continuation of the effort to have greater financial transparency, in particular in the financial statements for publicly traded corporations."


The white paper analyzes the potential impacts of both the mark-to-market requirement and the proposed lease accounting changes--which could go into effect as early as 2011 or 2012--and discusses courses that corporations can purse in order to mitigate the effects of the changes. The mark-to-market requirement, known as FAS 157, went into effect for financial assets as of Nov. 15, 2007 and for non-financial assets including real estate as of Nov. 15, 2008.

Anderson explains that one of the problems corporations face in marking down the real estate they own is that when a property is marked down, the write-down not only reduces the asset's value on the balance sheet, it generates a pre-tax loss on the income statement. The issue is further complicated by the difficulty of valuing real estate in a market in which few if any comparable sales are available because so few properties are trading. One of the steps that corporations can take to prepare for the impact of mark-to-market, Anderson says, is to review its properties before the end of the year to determine which ones have the potential to create write-downs.

"In the absence of comparable sales, you have to figure out how to establish a value for your property," Anderson says, and the time for a corporation to do that is before the end of the year when it is busy with so many tax and accounting duties that it will be hard-pressed to complete the tasks on time. "The corporate real estate department, if it understands what's going on in the mark-to-market arena, can come in early and start to take a look at its properties and basically create an argument for why it is valuing properties the way it is," he says.

The CBRE white paper points out that, "If a corporation has the financial wherewithal to carry the property until normalized market conditions return, the argument exists that the company should be able to avoid a distressed sale scenario in which the asset would be valued at a fire sale price."

Regarding the proposed changes in lease accounting, Anderson explains that the new rules would reclassify "operating" leases as "capital" leases, which in turn would require the operating leases to be reflected on corporate balance sheets instead of held off the balance sheet as they are now. Anderson comments on what a far-reaching change this could be: "Many companies can have as much liability for operating leases as they do for all of their other liabilities on their balance sheet, but operating leases today are not on the balance sheet," he says.

Under current practices, the only item that companies record on their income statements regarding operating leases is one year's worth of rent expense. "If you have a 10-year operating lease on a building, you will show nothing on your balance sheet and only one year of rent on your income statement," Anderson points out. He says that the argument in favor of reclassifying these as capital leases--which are reflected on balance sheets--is that operating leases are like bank loans, which are reflected on balance sheets. The argument is that an operating lease, like a loan, is an obligation of the corporation, not just for one year but for the entire duration of the lease. "The regulatory bodies are starting to say that such an obligation is too much of a financial component of a company to not be represented on the financial statements," Anderson observes.

Under the proposed accounting changes, corporations would compute the present value of all of their future lease payments and record them as both assets and liabilities on their balance sheets. "Just doing those two things alone could throw off debt covenants and various financial ratios that could have significant implications for a company's credit rating and other impacts," Anderson says.

The proposed changes would also affect how leases are treated on income statements, producing both depreciation and interest expenses, which would be greatest during the first half of the lease. The upshot is that corporations would take hits on their balance sheets in terms of performance ratios such as return on assets and debt covenant ratios, and they would also take hits on their income statements for the first half of the lease term.

The proposed changes in lease accounting have myriad implications for how companies structure and manage their real estate, Anderson points out. Not every company has the same proportion of owned versus leased properties, so the lease accounting changes would have very little effect on a company that owned the majority of its properties. A competitor that leased the majority of its properties, on the other hand, would suffer significant hits to its financial statements. One answer for such a company would be to execute shorter-term leases, which would show up as lesser obligations on the balance sheet, but the solution isn't always that simple: Not all real estate is suitable for short-term leases because the user may require long-term control of the property, Anderson points out. For properties that a corporation might need for 10 years or longer, it might be more practical to buy rather than lease because of the depreciation advantages of ownership.

Although the new lease accounting rules would not go into effect until 2011 or 2012, corporations should be looking at their real estate now to prepare for the potential impacts of the rules changes, Anderson advises. "Most companies are only beginning to understand these changes," he says.

Anderson notes that the accounting changes address only the user side of leases. "One of the big unknowns is what will this do to the landlord/investor side of the market," he says. Accounting standards boards have yet to tackle that question, so the answer "is truly an unknown right now," Anderson says.