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Is leasing still your best option?

October 31, 2011
by Marisa Manley
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Proposed FASB accounting rules could prompt more providers to buy space instead

The Financial Accounting Standards Board (FASB) has proposed a new standard to account for leases. The new rules can be expected to precipitate a shift in landlord-tenant relationships for behavioral health practices. For some, it could mean the end of the real estate lease.

Today, many behavioral health organizations and practices secure operating space through lease transactions. But the effect of the proposed FASB accounting rules will be to drive many space occupiers to buy instead. And, despite the longtime popularity of 10-year leases, those who opt to lease space may be inclined to choose shorter lease terms.

There are a number of reasons why the proposed rules will create a substantial uptick in space occupancy costs. In an effort to gain transparency, for example, these rules will greatly increase the amount of paperwork involved in executing a lease, as compared with owning.

The new FASB rules will also increase liability costs and issues. The new version of generally accepted accounting principles will require tenants to estimate all costs related to a lease-costs they neither control nor understand. If your facilities are covered by existing leases, you may think you are in the clear for now. However, the new standards will apply to both existing and new leases.

But, you may ask, what about smaller satellite office leases? Do the FASB changes cover all leases- leases on smaller satellite facilities as well as those on an organization's main office or largest facilities?

Under the new FASB rules, each lease is considered an entity unto itself. Regardless of the size of the space, each lease is considered individually and is covered by the pending rules.

Impact on non-profits

What about behavioral health organizations that are non-profits-501c3 entities under IRS rules? The FASB rules generally apply to publicly traded companies because the SEC has elected to adopt FASB standards. But, by law or regulation, many other entities must comply with FASB guidelines. Your tax advisor can advise whether your operations are covered by FASB rules.

All 501c3 organizations have public reporting requirements under federal law and state codes. In many cases, states require that reports be consistent with generally accepted accounting principles-in other words, FASB rules.

Also, often 501c3 entities have for-profit subsidiaries. These entities may be required to use FASB standards for all their operations.

In many cases, moreover, lenders or investors may require that generally accepted accounting principles be used by a behavioral health entity.

FASB's generally accepted accounting principles are not required of all organizations. However, under an interlocking mesh of governmental and non-governmental standards and regulations, the rules are nearly ubiquitous.

The main changes to lease-related accounting practices

Here are the main changes to generally accepted accounting principles affecting leasing that are now being proposed by the FASB:

The first change is that the right to use space is now to be shown on the balance sheet as an asset. The main obligations under real estate leases will be listed as liabilities.

The second change is that rental payments will be accounted for as loan payments carrying an imputed rate of interest. As with mortgage payments, only the imputed interest itself is deductible as a business expense. Up to now, there has been little official guidance on how to figure the imputed interest being paid to a landlord.

This provision could drive healthcare organizations to seek shorter leases that create uncertainty about how long they can maintain operations at a particular location. And it could encourage landlords to curtail “workletter contributions,” funds used for construction projects to improve a leased space. Shorter leases mean that landlords may not gain back such investments before the lease period ends.

Thus starts a process that could lead to disinvestment or, alternatively, behavioral practice management teams being encouraged to sink capital into real estate-a move that potentially limits cash to meet research, technology, or staffing needs.

Stay away from options

Options to extend a lease are problematic under the proposed rules. According to these rules, a tenant must treat a lease as incorporating the time covered by any renewal options which are “more likely than not” to be exercised. Thus, a behavioral practice with a 10-year lease and two consecutive five-year options to renew may be required by the regulations to treat the lease as a 20-year lease for balance sheet purposes.

Of course, few entities can predict with accuracy what their space needs are likely to be 10 to 15 years from now. And, even if a behavioral health organization expects to stay in place, determining likely lease payments years into the future is purely speculative, yet required for regular reporting under FASB's proposed standards. Under these conditions, tenants may be better off to avoid renewal options, even though that means they may never invest any funds in their space.

Estimate contingent payments

Marisa manley
Marisa Manley

Behavioral health organizations will now be required to estimate all of the contingent payments they will have as tenants under a lease-operating expenses, utility costs, and real estate taxes, for example-using “expected outcome analysis” based on “likely probabilities.”