Great post by Kaitlin Ugolik of Law360 on new accounting rules for leased properties.
Law360: New Accounting Rules To Spur Balance Sheet-Friendly Leases
Law360, New York (May 28, 2013, 8:05 PM ET) — New rules proposed this month by the top U.S. and international accounting boards that require companies to list all assets and liabilities from leases on their balance sheets have real estate attorneys preparing creative responses like additional security deposits and purchase options to compensate.
If adopted, the new rules proposed by the Financial Accounting Standards Board and the International Accounting Standards Board could fundamentally change the way lease deals and associated financing documents are structured, with a company’s overall financial status taking more of a central role in the process.
The rules aren’t final: They’re in their second round of public comments before standards are finalized next year. But experts are already debating how to approach the new leasing climate, which they say will call for more cooperation between company accountants and attorneys.
“Whether in-house or outside counsel, there is going to need to be a lot more cross-functional interaction, particularly in the development of major leases,” said Louis J. Battagliese, a founding principal of Jackson Cross Partners LLC, which works with real estate companies and attorneys on commercial leases.
“Core asset leases are going to require a little bit more communication and diligence with the finance and accounting and legal folks to make sure the lease is structured in a way that it’s not too punitive for the client,” he said.
Most real estate leases are not reported on lessees’ balance sheets because they are considered operating, as opposed to capital, leases. Many in the accounting industry have criticized this practice, claiming the omission of lease assets and liabilities from a company’s balance sheet provides an incomplete picture to potential lenders or investors.
In response, the FASB and IASB created a working group to update the standards, but the results have garnered their own criticism. The most recent iteration of the rules came after a significant backlash of the first draft in 2010, in which the real estate industry bemoaned a requirement that would have resulted in front-loading of lease expenses by lumping lease debt in with other types of financing.
One of the biggest issues for real estate companies and their attorneys in this process has been the question of amortization, experts say. It’s hard to determine how an individual lease will depreciate and work that into a company’s balance sheet. The FASB and IASB took notice of this in their updated proposal, allowing for leases to be listed as straight-line expenses.
“That was something [the real estate industry was] really pushing for,” said Julie Valpey, a partner at BDO USA LLP.
But the fact they will have to appear on balance sheets at all still rubs some experts the wrong way.
Information about the assets and liabilities related to individual leases isn’t currently hidden from lenders, experts say, and sophisticated financial institutions will ask for it if they need it. In addition, while putting the debt related to a lease on a company’s balance sheet may give a clearer picture of what is owed, the assets also reported may not be “true” assets.
“The people that are opposed to this rule will say we’re really not getting any better information regarding the company’s financial position,” said Gregory Spitzer, a partner in Paul Hastings LLP’s real estate practice.
And if the information is taken at face value, the leverage tests banks often use to see whether a borrower meets their expectations may become skewed, making it more difficult or expensive to get financing, experts say.
Attorneys say the clients that will be most affected by this potential change will be those operating within the sale-leaseback industry, selling property and leasing it back for the long term, and large corporations with bulky portfolios of properties, such as retailers and banks.
Those with large single-tenant portfolios will see a cumulative effect on their balance sheets, and those who operate primarily with sale-leasebacks will lose the appealing trait of being able to sell a property and take it off their balance sheet for the duration of the lease.
“[These rules] will completely eliminate the ability to do that,” Spitzer said. “It takes away some of the motivation for companies to do those transactions.”
In order to cope, attorneys likely will respond by structuring leases differently, perhaps adding new security deposits or negotiating for purchase options and altering the way they draft financing documents as well. It will most likely be necessary, experts say, to alter the “permitted additional indebtedness” in agreements to accommodate future lease transactions.
“From an attorney’s perspective, when drafting a lease, things that now appear to be in the interest of the client … may not be in their best interest if some of the changes they’ve proposed are deployed,” said Cate Sennett, an attorney and head of advisory services at Jackson Cross Partners.
In preparation for the potential changes, corporate counsel at many major companies have been looking to create a more coordinated system for working on leases alongside accountants and other financial advisers, Sennett said.
–Editing by Kat Laskowski and Richard McVay.