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.
A shortened version of this article titled
“Changing the Corporate Culture” appeared in the January/February 2012 CIRE.