What to Know About FASB and Your CRE

Topic 842, which is how the Financial Accounting Standards Board (FASB), refers to the 2016 document that redefined the rules for lease accounting, was approximately 10 years in the making. As of this writing in the back half of the summer of 2019, these rules are still not fully implemented across American business. That is changing. To understand the changes, though, we have to look at the history of this standard and how it relates to commercial real estate (CRE) tenancy.

FASB Lease Accounting: Past and Present

The preceding "normal" standard for accounting for actually dates back to 1976. Back then, the FASB set up two systems for lease accounting. Capital leases were treated as on-balance sheet activities while operating leases got treated as an off-balance sheet transaction. This means that companies could occupy space without having to recognize the right to occupy it as an asset or the obligation to pay for it as a liability.

This operating lease treatment became very popular. It allowed companies to control real estate for decades in some cases and rack out hundreds or thousands of locations without showing a single asset or liability on their books. Doing this allowed companies to show higher returns on assets since they had fewer assets. At the same time, they enjoyed full deductibility of all of their CRE lease payments since the IRS followed the FASB standard and allowed companies to treat their entire operating lease expense like any other non-capitalized expense.

This way of doing things was uniquely American. The rest of the world typically treated leases -- other than very short ones -- like capital events. They separated the lease into an asset, which corresponded to the value that the tenant got from the right to use the space for the given period of time, and a liability, which corresponded to the lease payments. In 1996, the International Accounting Standards Board and the US, United Kingdom, Canada, Australia and New Zealand drafted a paper to start thinking about how American lease accounting could start to follow the same rules as the rest of the world. In 2000, the IASB got serious about it and, thanks to the Enron scandal in 2001, the Securities and Exchange Commission started to look at the off-balance sheet nature of leases in the US.

Moving to ASC-842

As a result of this process, in 2006, the FASB began the process of creating a lease accounting standard that would bring American standards for CRE lease accounting more in line with those of the rest of the world. In 2009, they co-wrote a discussion paper with the IASB and after four years of discussion, a more formal draft was circulated in 2013. In 2016, that draft became a new international standard -- IFRS 16 -- and a new American standard, ASC-842, which is the current lease accounting standard, as modified one last time in 2018.

Understanding and Implementing ASC-842

Under ASC-842, leases have to be split into a right-of-use (ROU) asset on the balance sheet and a liability to go with it. The only leases that can be treated as non-capitalized items are very short term ones (typically less than one year). Public companies have had to follow this standard since the end of 2018 and private companies that follow GAAP have to follow it for fiscal years starting after December 15, 2019. Note that, as of mid-July, a proposal has been floated to delay implementation of ASC-842 for private companies until 2021. The status of this proposal is unknown, though, as of this writing.

When it comes to dollars and cents, there is good news. The IRS is not changing how they tax lease payments, so following the ASC-842 standard should not directly change your company's tax liability. The changes to your balance sheet, and the attendant increase in interest expense, could however, indirectly impact taxable income. As such, it is important to have an accounting professional help you assess your exposure.

Complying with ASC-842 also requires you to reconsider and revalue each of your leases. Instead of just accounting for expenses, you will have to value each right-of-use asset and correctly place it on the asset side of your balance sheet with corresponding entries for the liabilities on the other half. Doing this could require assistance from accounting and commercial real estate professionals as you need to determine the value of your assets before accounting for them.

What Hasn't Changed

While these provisions may appear to be designed to give CPAs and CFOs headaches, they aren't changing a basic truth about leasing. If leasing makes sense for your business, it will probably still make sense even under the new FASB lease accounting rules. Leasing still opens up additional buildings for you to apply, offers potentially lower costs than owning, and gives you more flexibility. For that reason, these seemingly big changes might actually be minor ones.