Will Publicly Traded Companies Soon Require Shorter Lease Terms?

Will Publicly Traded Companies Soon Require Shorter Lease Terms?

NEW ACCOUNTING LAW FOR CRE, EFFECTIVE 2017 

The U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are proposing operating lease obligations be included on company balance sheets, effective 2017. Corporate accounting scandals involving off-balance-sheet transactions in 2001, including Enron and Worldcom, which lead to the Sarbanes-Oxley Act, were the springboard for this desired change to lease accounting rules. 

IMPACT ON COMMERCIAL REAL ESTATE

Leases currently classified as operating leases will soon require posting on the balance sheet.

Under the proposed accounting requirement, the net present value of the lease liability can, potentially, destroy the debt to equity ratio, and here's how: Say, for example, Major Corporation A has 5000 operating leases across the United States. Before the operating leases are moved from a footnote to a balance sheet transaction, the debt to equity ratio is .25.  These operating leases are also posted as an asset on the balance sheet, keeping the equity position at the same value; however, a new large liability has been posted, which effects the debt to equity ratio substantially, and return on assets (ROA) ratio. Depending on lease values and remaining lease terms, it would not be surprising to see the debt to equity ratio jump to .75, for the same company with no actual change in financial position. 

This accounting change may put pressure on companies to sign shorter leases or incorporate escape clauses so that the liability will be limited on the balance sheet.

THE BIG QUESTION: How will this impact both lending and stock value?  When operating leases become on- balance-sheet liabilities, will lenders and investors maintain their faith in the financial security of corporations? After all, these leases have been in the footnotes all along; have they simply been historically glazed over?

To gain a better understanding of commercial lease classifications and current accounting rules, see Lease Classification