With the deadline for compliance with new lease accounting standards set by the FASB and the IASB looming, many finance executives are still racing to meet the deadline.
If your organization leases commercial real estate, your entire approach to lease accounting and financial reporting — and even the necessary capabilities of your accounting technology — will never be the same again.
The new ASC 842 and IFRS 16 standards will fundamentally transform the rules that govern accounting for almost all types of leases including real estate, vehicle and equipment leases. Although some low dollar value and short-term leases, as well as service agreements which sometime look and feel like leases, are excluded. The changes are expected to have far-reaching implications in accounting, financial planning and reporting, real estate portfolio management and tax compliance, and especially in lease accounting technology, such as financial management software.
Under the new rules, companies will can no longer simply record operating leases as a period rent expense. Instead, they’ll have to appear on the balance sheet as an obligation and a related right of use (asset). Some experts believe this could make IASB Income Statements much more volatile in future. Balance sheet effects under both standards will include a substantial impact on an organization’s debt/equity and other ratios. This could result in an adverse effect on a company’s overall credit worthiness. According to some estimates, the new lease accounting rules could add as much as $2-3 trillion to the balance sheets of companies in the United States and over £60 billion in the UK.
Many companies are hyper focused on compliance, working quickly to put solutions in place that will centralize, validate and augment existing lease data to ensure completeness and accuracy. The market today is heads down thinking, “how can we get compliant by January?” but what most aren’t thinking about is, what comes next?
Supply and Demand
At the end of the day, real estate is a function of balancing supply and demand. On the demand side, you have the space needed for the business and on the supply side you have a certain amount of buildings that you either own or lease. From a finance perspective, it’s all about optimizing the real estate portfolio given the amount of liabilities you have leased and the assets you hold.
The new lease accounting standards aren’t actually changing that supply and demand, but they are changing how you report a component of the supply on your financial statement. As mentioned, rather than a footnote in your financial statements, leased space will go on your balance sheet as both a liability and an asset.
For some companies, this means anywhere from $5 billion, $10 billion or more on their balance sheets. With this hefty liability, CFOs and finance professionals should consider inviting corporate real estate to the table as questions such as ‘how can we manage our portfolio to minimize this new liability’ and ‘how can we more proactively control it?’ begin to surface. Once compliance is achieved, it’s time to start thinking about how to manage the liability in order to drive positive balance sheet ratios, such as debt-to-equity, and ensure your organization isn’t carrying more debt than necessary.
Space Management and Utilization
As the attention turns to more efficiently and proactively managing the portfolio, companies should shift their focus to occupancy and understanding space utilization. Going back to supply and demand, the more efficient you are with your space, the less of an adverse impact it has on your balance sheet. This means your business requires less space, lowering the occupancy cost per square foot/meter, and as a result, reducing your liability, as well as operating expenses reported in your income statement.
By aligning with the corporate real estate team, you can identify which leases have the highest exposure on financial statements and evaluate which business units are occupying them, how densely those spaces are populated and how they’re being utilized.
It’s a well-known fact that on average, an office workspace density is between 40 and 60 percent. If we look on the low end of this spectrum, this means that at any given time, most businesses are only utilizing half of their leased space. The new lease accounting standards provide an opportunity to re-evaluate the space and thus, impact the liability of leases on the books. Working with the corporate real estate team, you can evaluate the leases by looking at how that leased space is being utilized relative to its impact on the financial statements. While there are a number of actions that can reduce your liability, the most effective is to evaluate office utilization alongside the lease debt to identify opportunities.
Where to Start?
Evaluate which leases are causing the biggest pain. When are they up for renewal? What are the options for those leases? What is the current utilization? For example, if you have a really poor performing building (underutilized) but signed a 10-year lease last year, you need to do something different with that space.
Consider these Options:
Do you have an option to move people from other business units into that building and consolidate other buildings nearby that may be nearing their lease expiration?
Is the market good for you to sublet? Looking at market data can help evaluate if the market is ripe for this option. Maybe you’re in it for $70 per square foot but you can sublet it for $75 per square foot.
Is there a buyout option on the lease?
Is there an opportunity to terminate a lease early? This may involve a short-term penalty but may result in a long-term gain.
The Bottom Line
Rather than viewing compliance as a challenge, look at it as an opportunity. Get strategic with leased asset portfolio planning so that the leasing process is not just a one-time consideration. Leases and utilization of those spaces are something to continually monitor and evaluate on a quarterly basis. An integrated lease accounting and space management solution will give your organization the perfect tools needed to understand the available options and actively manage your portfolio.
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