A few weeks ago, the two accounting boards behind the biggest shake-up of the accounting treatment of leases in 30 years caused a great deal of uncertainty for private equity and real estate investors.
Having introduced an ‘exposure draft’ last August, all seemed clear – operating leases, which included property
leases, would be dealt with just the same as finance leases. But following outcry and opposition from different industries, the London-based International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) have appeared to backtrack.
In the last few weeks, the two accounting boards have embarked on a second ‘outreach programme’, suggesting that key elements of the draft – which the boards want to finalise as a standard this year – could be different to what was proposed last summer.
On the face of it, lease accounting hardly sounds like something to set the pulse racing. However, the industry has spent a lot of effort in investigating how to incorporate something that would have had a far-reaching impact, according to property experts at Cushman & Wakefield and Richard Ellis.
Put simply, in its previous guise, the new lease accounting model would have forced everybody that reports under US generally accepted accounting principles (GAAP) and the International Financial Reporting Standards (IFRS), which together are a significant portion of the world, to stop the practice of accounting for operating
leases “off the balance sheet.”
At the moment, companies can simply disclose their future rent liabilities in footnotes to their financial statements. It also would have led to a different accounting treatment of leases on a company’s profit and loss account. In particular, op-co and prop-co structures that private equity firms have gravitated to when buying operating companies laden with real estate would have been significantly affected.
Under the present system, liabilities of a lease and the corresponding asset value attached to that lease reduce on a straight line basis, but under the August 2010 proposals the depreciation would have been weighted towards the beginning of the lease. This front-weighting also would have been reflected in the company’s income statement, meaning that, on paper, a company’s profits would go down materially.
Under the August proposals, a private equity firm that wanted to perform an op-co/prop-co split would have experienced a very significant increase in liabilities and a reduction in profits.
As a result, banks lending to that private equity firm on the deal might call for more equity, which could have fundamentally changed the returns of a deal, suggested David Martin, senior director of real estate finance at Richard Ellis.
The new rule also would have affected private equity firms that recently had taken over a company and performed a sale and leaseback, as income cover ratios might have come under strain. “Under the new accounting standard proposed in August, a private equity firm might still enter into a sale and leaseback, but it might not be as advantageous,” Martin said.
In addition, valuations of existing portfolio companies or potential new investments with large rental obligations would have had to change. This is because the original draft set out that rent paid under a lease would not be counted when calculating the operating profit of a company, or earnings before interest, taxes, depreciation and amortisation (EBITDA). Instead, it would have been a cost deducted as interest and depreciation after the calculation of EBITDA – or “below the line,” in accounting jargon.
Theoretically, the multiple applied to that company would be adjusted (although the actual value of the company doesn’t change), Martin said. Overnight, private equity firms would be paying three times EBITDA rather than four times for a retailer, which would have meant that historic multiples paid by private equity firms for companies with many property leases might not have provided a useful benchmark any longer.
“They might have had to use a different measure altogether,” he added.
Finally, under the August 2010 proposals, it is suggested occupiers might react to the changes by altering the common way they sign leases. Matthew Stone, partner in Cushman & Wakefield’s EMEA capital markets team, said occupiers might have opted for shorter leases and in return agreed to pay higher rents because they would have had to account for the totality of their rental exposure in the future. “If managed properly, this would be an opportunity for more proactive investors to drive returns and also create premium investment pricing for longer-term leases,” he said.
All these issues have now been thrown into deep doubt after the accounting boards decided to reconsider what was proposed in the draft. In reaching out to experts like Richard Ellis and Cushman & Wakefield, the indication is that, instead of categorising property leases as operating leases, they will fall into a new category with the catchy header “other than finance leases”. Until the new round of consultation is over, however, how property leases will really be accounted for remains up in the air.