On February 25, 2016, the Financial Accounting Standards Board (FASB) issued a new Accounting Standards Update (ASU), Leases (Topic 842). The new rule makes significant changes to the FASB standards for lease accounting by requiring tenants and other lessees to recognize assets and liabilities for certain operating leases, which were traditionally kept off-balance sheet.

Under current US generally accepted accounting principles (GAAP), leases are categorized as either capital leases or operating leases. A capital lease (for example, a lease of equipment for nearly all of its useful life) is a lease that has any one of the following characteristics:

An operating lease (for example, a ten-year retail lease) is a lease that does not meet any of the criteria for capital lease status.

Currently, capital lease assets and liabilities are recorded on a lessee's balance sheet while operating lease assets and liabilities are not. This distinction allows lessees to manipulate the makeup of their balance sheets by structuring leases to avoid capital lease status. As a result, financial statement users cannot effectively compare different entities and the impact of their leasing decisions.

The newly issued ASU aims to increase transparency and comparability among entities, ending what investors, the SEC, and other financial statement users have long regarded as one of the largest forms of off-balance sheet accounting.

Under the newly issued ASU, for operating leases with terms longer than 12 months, lessees must now:

The FASB changes to lease accounting standards for lessors are largely limited to conforming changes that align lessor treatment with the new lessee treatment. Lessors must continue to classify the vast majority of operating leases as operating leases, and generally continue to recognize lease income for those leases on a straight-line basis over the lease term.

These changes in balance sheet reporting will have drastic effects on how companies hold real estate and may present significant operating challenges upon implementation.

The FASB changes will impact whether companies decide to lease real property at all, rather than purchase it. While historically many companies chose to lease real estate assets in order to keep significant long-term obligations off their balance sheets, the new accounting standards will cause companies to reevaluate that decision.

Companies that do choose to enter into leases will want to change how those leases are negotiated. Tenants should consult with counsel to determine whether they should seek:

Companies with existing operating leases may face implementation costs arising from the need to keep a more detailed database of their leases. Additionally, the inclusion of operating leases as liabilities may also upset companies' debt-to-equity ratio, which might require the renegotiation of existing financing covenants to avoid being in breach.

The changes will become effective for public companies for fiscal years (and the interim periods within the fiscal years) beginning on or after December 15, 2018. For all other entities, the changes will become effective for annual reporting for fiscal years beginning on or after December 15, 2019, and interim periods within the fiscal years beginning after December 15, 2020.

For more information on commercial leases, see: