Impact of lease accounting changes to corporate real estate

In February 2016, the Financial Accounting Standards Board (FASB) issued its long-awaited revision to lease accounting—Accounting Standards Update (ASU) 2016-02, Leases (codified as FASB Accounting Standards Codification (ASC) Topic 842) (the Standard). This Standard modifies accounting for lessees and lessors and is effective for (a) public entities¹ for annual periods beginning after December 15, 2018 (calendar periods beginning after January 1, 2019) and interim periods therein and (b) all other entities for annual periods beginning after December 15, 2019 (calendar periods beginning after January 1, 2020). Early adoption is permitted for all entities.²

While all leases will need to be considered under the Standard, there are significant ramifications to leases involving real estate.

• Tenants (lessees) will be most impacted by the requirement to recognize liabilities and assets associated with leases on the balance sheet, including leases classified as operating leases. This likely will result in a balance sheet with dramatically higher assets and liabilities, particularly early in the lease term.
• Landlords (lessors) generally will maintain existing lease accounting guidance for the balance sheet, income statement and cash flow statement. For the majority of landlords who currently account for leases as operating leases, the Standard will not change the current straight-line recognition of rental income over the lease term.

Both tenants and landlords will be impacted by changes to nonlease components, initial direct costs and required disclosures. All entities will have to revisit their existing accounting and control processes. Separation of nonlease components from lease components is typically not difficult for most real estate entities. However, the Standard will likely introduce some complexity.

Entities should begin the strategic planning necessary to meet these new challenges well before the effective date. Further, financial statement users should be notified about how these changes to lease accounting will impact presentation of leverage and ratios. In particular, tenants will see higher noncurrent assets and higher current and noncurrent liability amounts on the balance sheet. This will lower some liquidity metrics (such as current ratio and quick ratio) and performance metrics (such as return on assets). Furthermore, by increasing overall liabilities, leverage metrics (such as debt ratio or debt-to-equity ratios) will appear higher.

¹ For purposes of determining the effective date, public entities include publicly owned business entities, not-for-profit entities that have issued or are conduit bond obligors for securities that are traded, listed or exchanged on an over-the-counter market, and employee benefit plans that file or furnish financial statements with the Securities and Exchange Commission.
² The SEC announced that public business entities that otherwise would not meet the definition of a public business entity except for the requirement to include, or the inclusion of, its financial statements or financial information in another entity’s SEC filing may defer implementation until annual periods beginning after December 15, 2019. Please refer to RSM’s Financial Reporting Insights Article for more information.