The Financial Accounting Standards Board and the International Accounting Standards Board aim to create a unified set of lease accounting standards as part of a larger global convergence initiative. With the goal of improving lease information transparency and comparability, the new standards could have residual effects on the way in which companies form decisions regarding their real estate needs. The single most impactful change of the proposed lease accounting standards would be the elimination of the distinction between capital and operating leases. Under the proposed guidelines, companies would be required to recognize every leasehold obligation (in excess of one year in term length) on its balance sheet.
As a component of research conducted for a graduate thesis project, two students from the MIT Center for Real Estate interviewed representatives from 29 companies of various profiles in order to answer the question, “Would the proposed changes to lease accounting have an impact on corporate real estate decisions?” The students sought to predict if, and to what extent, the proposed changes to lease accounting guidelines could alter the corporate real estate decision-making process.
A company’s real estate strategy is formulated by assessing a multitude of different factors. The relative importance of each factor should be determined by the role each plays in supporting that company’s underlying business goals. For certain companies, the accounting effect of real estate decisions can be of critical importance. For these companies, major changes to lease accounting could significantly impact overall real estate strategy.
To determine why accounting plays a role in real estate decisions for certain companies, the students used prior research to understand the primary drivers for corporate real estate strategy. In addition to more common issues such as locational requirements, future growth expectations, financial cost, and company risk profile, empirical evidence suggests a company’s sensitivity to financial statement presentation may be a substantive variable in decision-making. Publicly-traded companies face heavy scrutiny from rating agencies, company analysts, and investors. For those companies that identify flexibility in the other issues affecting real estate strategy, a real estate decision that yields a more positive accounting treatment may be pursued. Past evidence suggests companies adjust transaction parameters (albeit, marginally) in order to achieve beneficial accounting treatment. The measurable, rule-based criteria currently used to differentiate capital from operating leases (known throughout the industry as the “bright-line” tests) allow for creative structuring of leases to obtain off-balance-sheet classification. Since the issuance of SFAS 13 in 1976, the industry has experienced a significant increase in operating leases and corresponding decrease in capital leases, signifying a willingness by companies to compromise other issues more central to operational goals in an effort optimally classify leases under the current accounting guidelines. With the prospect of a new lease accounting framework on the horizon, the question becomes whether a more beneficial accounting treatment is worth the degree of compromise that would be required of these other issues.
To examine this question, the students conducted targeted interviews with a diverse sample of companies representing tenants, landlords, and other industry professionals, from both the public and private sectors. The research primarily explored whether companies would modify typical lease structures in order to reduce the liability that is capitalized on the balance sheet and whether companies would consider owning versus leasing as a real estate strategy since the balance sheet impact under the proposed accounting changes would be similar.
Based on their research, the students concluded that the proposed changes in lease accounting would not cause an industry-wide shift in corporate real estate strategy; however, for those companies that value the accounting impact of real estate decisions to a greater degree, the proposed changes to could be a catalyst for changes in real estate behavior. The impact for a particular firm would be largely based on two main factors (i) the size of a company’s operating lease portfolio relative to its balance sheet and (ii) a company’s sensitivity to financial statement presentation. These factors make a company more likely to change its behavior to mitigate the effects of the proposed changes. As a result, some companies may be more inclined than others to lessen the balance sheet impact of the proposed accounting changes by modifying their current corporate real estate strategies. However, for other companies, a more attractive balance sheet presentation would simply not be worth the required tradeoff in operational flexibility or financial cost.
The students also discovered through their research that the proposed accounting changes would require companies to incorporate sophisticated lease tracking systems in order to comply with the new reporting requirements. For example, since a balance sheet entry for a particular lease could change over the lease term based on the likelihood of certain events (i.e., the exercise of a termination or renewal option), more analysis and more communication between internal departments would be required. For instance corporate real estate groups would need to discuss transactions with corporate finance and accounting groups. As a result, companies would scrutinize their real estate footprint in greater detail and have a greater awareness of any inefficiency in the space they occupy. Companies would be better equipped to make real estate decisions that would lead to increased efficiency in the market. Going forward, determining real estate strategy will continue to involve many economic variables, however, in certain cases, the proposed lease accounting changes may be a variable of enough importance to justify a change in strategy.
Timothy Robert Canon was a senior analyst for Boston-based real estate advisory firm Richards Barry Joyce & Partners, and Christina Anne Fenbert is a portfolio analyst for Colony Realty Partners in Boston. It should be noted that, as of the date of the publication for this article, the revised lease accounting rules have not yet been finalized. In fact, FASB and the IASB have stated a second exposure draft will be issued in early 2012 due to the collective response from companies to the initial exposure draft. As such, responses from companies, from which any inferences were drawn, were based on the tentatively agreed upon changes, as of July 2011.