It seems like every accounting, real estate, and asset tracking software firm has published an article on the new FASB Lease Accounting Standards. I’ve noticed that they all tend to talk in generalities about the actual mechanics, and none that I’ve found seem to offer suggestions from a corporate user perspective aside from “Get ready!”.
The reason this is a big concern is that operating leases, likely such as the one for your company’s existing office or warehouse spaces, will soon have to be shown on the balance sheet. They will appear as both a “right-of-use” asset and a corresponding liability. So if you have both a liability and an off-setting asset, it is a wash, right? Well, yes but from a credit standpoint it is still less favorable. Here’s an example of how a balance sheet might look for a company with $1M of assets and a $1M operating lease both before and after:
BEFORE: Assets: $1,000,000 Liabilities: $0
AFTER: Assets: $2,000,000 Liabilities: $1,000,000
The net equity remains the same, but in the Before scenario the user has no debt and in the After scenario the user has 50% debt. Less desirable.
So the objective will be to minimize the impact. Because this is a complex issue, and there are many parts that are open for liberal interpretation, please do not underestimate the value of good legal and accounting advice and I hereby recommend that you seek an opinion from your own advisor. That disclosure out of the way, here are my observations:
- Term: Shorter is better. You can try to hedge your risk with options, but if it is “likely” that you will exercise the option (meaning that you have strong financial incentive to do so), you’ll need to capitalize the option period(s). Making a large investment in improvements or having a below market renewal option would trigger this “likely” opinion.
- WACC the Discount Rate: Both the asset and the liability are determined using a discounted Net Present Value (NPV). You can use your incremental borrowing rate or the “risk free” rate. Of course, you want the highest possible discount rate, because this will reduce both the asset and liability values. Intuitively, you might expect to use your incremental debt borrowing rate (for a like term), although consider instead your Weighted Average Cost of Capital (Google it if you need the formula) which will likely boost the rate by factoring in a higher return on equity.
- Float the Taxes: If a Base Year is used for Property Taxes (including if bundled in a full service lease as is currently common practice), then the taxes must be capitalized. But if the tenant is responsible for their proportionate share of property tax whatever those taxes may be (as in a NNN lease for example) then they are not capitalized. This can make a very significant difference, and a smart real estate advisor can install some protections that limit or eliminate the risk of negative surprises.
- Parking Optional: Designated parking spaces included in the lease are capitalized. Instead, negotiate the option but not the obligation to take reserved parking.
- Track Direct Costs: Tenants can add the value of related direct costs paid to 3rd parties to the asset value such as legal fees, brokerage or consulting fees, and related travel costs. Track these costs by project as they can be added to the asset and straight-lined over the lease term separately from the lease present value.
The new guidelines are “principles” and not “rules”, so there is much room for interpretation and, while it must be reasonable, it can also be structured favorably. Because when it comes to balance sheet impact, Less is More.