On February 25, 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2016-02 (the “ASU”),
which will materially alter how tenants account on their financial statements
for most real estate leases. Substantially all businesses that lease space,
including office, retail, warehouse and industrial space, and prepare
financial statements in accordance with GAAP, will be impacted.
Under current FASB, only “capital leases” (i.e., a lease which
is effectively a sale or a method of financing the sale to the tenant
of the real property) are required to be recognized as an asset and a
liability on a tenant’s balance sheet, while other leases are simply
noted in a footnote to the financial statement. This will change under
the ASU pursuant to which, among other qualitative and quantitative disclosures
that will now be required, tenants will be required to recognize “operating
leases” as both an asset and a liability on their balance sheets.
Under the ASU, an “operating lease” is generally defined as
a lease providing for the use of the leased asset for a term of greater
than one year and which is not effectively a sale or a method of financing
the sale to the tenant of the leased asset. In accordance with the ASU,
the liability under each operating lease will be calculated based upon
the present value of the remaining payments over the term of the lease,
and the asset valuation will be calculated based upon such present value
as adjusted for a tenant’s lease prepayments, lease incentives and
initial direct costs.
The newly-issued ASU is meant to promote financial transparency and comparability
among businesses, as well as to close a perceived loophole with respect
to off-balance-sheet financing. As mentioned above, currently under GAAP
only assets and liabilities with respect to capital leases are required
to be recognized on a tenant’s balance sheet, while operating leases
typically are disclosed in the footnotes. By only requiring certain disclosures
in the footnote, the FASB concluded that in many cases the economic impact
of operating leases was not being adequately considered by parties relying
upon a company’s financial statements; and in some cases, the relevant
liability was being overlooked completely. Accordingly, the FASB concluded
that the failure to include these assets and liabilities on the balance
sheet rendered the financial statements inaccurate and misleading. By
requiring the recognition of an asset and liability with respect to a
company’s operating leases directly on the balance sheet, the FASB
believes that the users of financial statements, such as lenders and investors,
will have a more complete financial picture of the company.
Potential Impact on the Commercial Real Estate Market
As is often the case with changes in accounting standards, as well as laws,
the changes may have unintended consequences on the affected industries.
Paradoxically, the following consequences could arise notwithstanding
the fact that no economic change has occurred in the financial condition
of the tenants by reason of this change in reporting requirements.
Financial coverage ratios and financial covenants: By now requiring the
inclusion of operating lease liabilities (i.e. rent payments) on a tenant’s
balance sheet, the tenant’s financial ratios (such as the debt/equity
ratio) could be negatively impacted. In addition to potentially having
an adverse effect on how the tenant is viewed by potential investors and
lenders, the new rules under the ASU could increase the tenant’s
liabilities (or negatively impact such ratios) to such an extent that
would put the tenant in violation of financial covenants under applicable
leases, financing documents or other applicable agreements.
Shorter lease terms, more net leases: Where market forces permit, tenants
may negotiate shorter-term leases with more renewal options in order to reduce (or even eliminate) the amount of the liability that
needs to be reflected on their balance sheets. Also, because the present
value of fixed rent payments, as opposed to payment of real estate taxes
and operating costs (such as insurance, maintenance and repair costs)
must be recognized as a liability under the new rules, tenants may seek
to have leases structured on a more “net” basis (i.e., reduce
the fixed rent, in exchange for tenant’s payment of taxes and operating
costs). The impact of tenants desiring shorter lease terms and structuring
leases on a more “net” basis could have a considerable impact
on lease underwriting for both real estate investors and lenders.
Purchase vs. leasing real property: For almost all business organizations,
the decision to purchase or lease space in order to meet their space requirements
involves the consideration of many factors, including costs, availability
of financing, desired flexibility and risk assessment. Given the adverse
impact that the ASU will have on a tenant’s balance sheet, many
tenants may reconsider the option of purchasing real estate, in lieu of
leasing, in order to meet their space needs. Although it is too early
to predict whether the commercial real estate sale and leasing market
would actually see any shift due to these new rules, it is certainly something
to be mindful of as these rules get implemented.
When ASU Is Effective
The reporting requirement changes under the ASU are to be implemented at
different times for public and private companies. For public companies,
operating leases will be required to be incorporated on balance sheets
in fiscal years and interim periods within those fiscal years beginning
after December 15, 2018. For a calendar-year public company, this change
would therefore go into effect on January 1, 2019. For non-public companies,
the financial reporting change will take effect for fiscal years beginning
after December 15, 2019 and for interim periods within fiscal years beginning
after December 15, 2020. All companies are permitted to voluntarily begin
reporting in compliance with the ASU before these dates.
Actions to Consider
While there is time before businesses must implement ASU, companies that
lease commercial space and are subject to GAAP should take a proactive
approach and examine whether their existing operating leases might violate
any financial covenants and consider taking steps to address them. In
addition to tenants, real estate investors, lenders and landlords should
certainly note these changes in financial reporting standards in connection
with their financial due diligence and underwriting activities in the future.
For more information on the topic discussed, contact
Eric S. Schoenfeld at
email@example.com or 212-508-6713,
Ari Davis at
firstname.lastname@example.org or 212-508-6796 or your Tannenbaum Helpern contact.
 The FASB is a not-for-profit organization that establishes financial accounting
and reporting standards for non-governmental organizations in the private
sector, which follow Generally Accepted Accounting Principles (GAAP).
FASB had initially worked together with the International Accounting Standards
Boards (IASB) (for companies that follow International Financial Reporting
Standards) to jointly issue guidelines on financial reporting for leases.
The IASB issued IFRS 16 in January 2016, which aligns with ASU 2016-02
in many respects (i.e. requiring leases to appear on balance sheets),
but differs in certain material areas.
 Under FASB accounting standards, certain renewal option periods may need
to be included in the calculation of the term of the lease.
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