Rules governing the way leases are accounted for on balance sheet rules are expected to change in the first quarter of 2016 with major implications for retailer tenants and longer term implications for landlords.

Today, real estate leases are generally not accounted for on most tenants’ balance sheets. That is, such leases are regarded as neither assets nor liabilities.  A suite of rule changes related to leases is expected from the Financial Accounting Standards Board (“FASB”), the private, non-profit organization that establishes the rules governing generally accepted accounting principles used in the United States. The most significant FASB change would require a tenant to include any lease greater than one year as a liability and an asset on its balance sheet.  The amount of the liability would be the present value of the total rent remaining due under the lease, however, there may be some unexpected consequences as the new rules are fully implemented.

What Do the Rule Changes Mean for Tenant Retailers?

Tenants would be most directly affected by the proposed accounting rules change and would be required to treat the present value of any lease greater than one year as a liability and a corresponding asset on its balance sheet.  The tenant’s right to use the real estate is the asset, and its obligation to pay rent is the liability. A lease would be recognized as a single cost. That cost would include any interest on the lease liability. The asset would amortize on a straight-line basis.

For some tenants the rule change could pose major concerns such as newly-disclosed lease liabilities causing violations of lending covenants regarding balance sheet ratios or increasing borrowing costs.  A third category of potential headache for tenants is actually doing the accounting – tenants will have to devote the time and resources to reviewing and accounting for leases, perhaps including existing leases, depending on how the rules ultimately unfold.

What Do the Rule Changes Mean for Landlords?

The rule changes regarding leases will have technical implications for landlords as well, but the more significant implications are likely to arise in connection with future lease negotiations. For instance, a tenant may seek to keep its lease term shorter to reduce the amount of “debt” on its balance sheet.  This may shift the market toward shorter leases.

The rules may also change the economic dynamics regarding fixed rent, percentage rent, and CAM. Under the new rules, a tenant may treat fixed rent expenditures differently than variable expenses when determining the present value of future year lease payments. A tenant is required to account for only the fixed rent obligations of the lease. Consequently, tenants may clamor for lower fixed rent in exchange for making a greater portion of its payment in variable costs such as CAM or as percentage rent.

In addition, landlords as well as lenders and financial analysts will have to keep the rule change in mind when reviewing a prospective tenant’s balance sheet for creditworthiness as any prospective tenant with other leases will appear to have liabilities that it would not be reporting today.

Finally, the final rule change is likely to include a sort of “grandfathering” provision for leases in effect before the rules take effect according to the timeline discussed below, and some tenants may rush to finalize lease amendments granting additional extension periods before that time.

When Do the Rule Changes Take Effect?

The rules have not yet been finalized. As noted above, FASB expects to release the final rules early in 2016. Most observers expect the rule changes to occur as expected, but the rule changes have been in development for more than a decade already, have previously been delayed, and there has been tremendous opposition from businesses that have large lease portfolios and would be affected most by the rule change. However, the safe bet is on the rule change occurring this year.

Once the rules are adopted, they will not go into effect immediately, and the timing of the effectiveness of the rule change will vary slightly for different types of tenants. Most publicly traded companies will have to begin to adopt the new accounting rules for fiscal years beginning after December 15, 2018. All other entities will have to begin to adopt the new accounting rules for fiscal years beginning after December 15, 2019.

Why Are the Rules Changing?

FASB’s objectives with the new rules are to ensure that financial information is transparent and objective. The proposed lease accounting standards have roots that are decades’ old, tracing back to the dubious practice of keeping assets off of its balance sheet, which in part contributed to the collapse of companies like Enron. With the economic crisis of the last decade also involving off-balance sheet shenanigans, momentum re-emerged for improved disclosure of financial liabilities, including leases.