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Accounting shakeup set to cause stir in office leasing as off-balance sheet activity becomes thing of the past.

A new accounting standard is in the works that, when passed, would drastically change the way leases are accounted for.

Leasing has historically afforded the advantage of providing companies with a form of off-balance sheet financing.

Although lessees have the right to use the leased premises, they currently do not reflect all lease obligations on their balance sheet. Instead, they provide disclosure of the lease terms in the notes to the financial statements.

The accounting change is meant to bring to an end off-balance sheet activity for leases.

The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) are working on a joint project to create common lease accounting requirements that would require assets and liabilities arising from lease contracts to be recognized in the balance sheet.

Lessees will record a liability on the balance sheet for its obligation to pay rent, and an asset representing its right to use the leased premises. The new rules will apply to new leases, as well as existing leases.

These changes will impact virtually every industry. Users of real estate, as well as any company that leases equipment or other assets, will be affected by the new rules.

Many companies are already struggling in the current economic environment, especially those with high leverage. Additional liability on the balance sheet for these companies will impact debt covenants with lenders, alter investor perception, and possibly affect credit ratings.

Because many companies will be required to record significant liabilities arising from leases, it is likely that users of leased property will consider shorter lease terms to minimize the negative impact.

If a company is considering a 10-year lease, they might now consider a 5-year lease, because it means putting half as much liability on the balance sheet as a 10-year lease.

The lease term used to measure the asset and liability would be the longest possible lease term that is more likely than not to occur, considering all relevant option terms.

Many leases currently contain renewal options, therefore tenants may opt not to include renewal options in new leases to minimize the impact of the liability arising from the new rules.

In addition, since off-balance sheet financing will no longer be allowed, companies that presently lease their space may instead develop a long-term strategy to own. If this trend occurs, it will reduce the demand for leased space.

Retailers will be especially challenged because their leases usually include contingent rents. Contingent rents are rental payments based on the percentage of the retailer's sales. The new rules would require retailers to estimate their future sales and then reassess these estimates each time they report results.

Real estate owners will also be affected by the new accounting rules.

Landlords would record a liability for their obligation to provide space and record a corresponding asset (lease receivable) representing their rights to receive rental payments from the tenant. Property values have declined dramatically in light of the recent global recession. Many real estate owners are struggling with declining cash flows and high leverage.

The market provides both challenges and opportunities for real estate users. A real estate user that has a better credit profile and lower cost of capital compared to a particular landlord may be well positioned and decide to own the property rather than to rent.

It is likely that the new standard will be completed next year by the FASB and IASB and enacted in 2013.

Public companies and private companies that report financial results using generally accepted accounting principles (GAAP) will have to comply.

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Comment:Accounting shakeup set to cause stir in office leasing as off-balance sheet activity becomes thing of the past.
Author:Moreh, Shahab
Publication:Real Estate Weekly
Date:Aug 4, 2010
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