By now you’ve probably heard about the FASB lease accounting changes. People are upset. Retailers and lessees across the country will soon need to recognize leases on their balance sheets as liabilities, removing the beloved option to footnote long-term lease obligations. With all this moaning and groaning, wouldn’t it be nice if someone had good news about how these changes can be used to work in your favor? For banks, it is a real possibility.
Let’s say you have branches in your network that have been on your books for a number of years. By now, these older locations have depreciated and have little or no book value. While there is nothing wrong with these buildings, much of their value has fallen off your balance sheet, especially when viewed against their potential market value. You’d like to sell them and unlock that embedded value, but you also are not interested in moving your branches and potentially disturbing or losing customers. Unfortunately, to date, your ability to easily recapture value while continuing operating in branch locations has been challenging: based on the old revenue standards, full market value generated through a sale-leaseback did not result in an immediate recognition of a full gain. However, this is changing…
The new FASB accounting rules, in concert with the newly established US GAAP revenue recognition rules, now allow banks to unlock real value from their depreciated branches through the strategic use of sale-leasebacks. Sale-leasebacks are not new to banks. Many banks have used sale-leasebacks in the past to alleviate property management burdens, to eliminate non-core distractions, to eliminate non-core investments, and to benefit from the sale of vacant co-tenant space. However, the previous accounting rules had a downside: gains generated through the sale of a lease-backed asset were deferred over the term of the lease. For example, a branch with a book value of $600,000 that sold for $1,000,000 with a 10-year leaseback term of $20,000 a year required a deferral of the $400,000 gain over the term of the lease. The $400,000 gain would be recognized as $20,000 yearly adjustments over 10 years (the gain minus the sum of the annual lease payments spread across the lease term). All that potential value trickled back in over the lease term, which made it tough for a bank to use to their advantage. That’s why the net present value of the $400,000 would only be $147,202 at a discount rate of 6%.
The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) discerned that this was not the best or most accurate way to record revenue or leases under these specific circumstances. Now, as long as control and use of the asset passes from seller to buyer and the seller does not substantially consume the economic life of the asset over the term of a leaseback (bank branch sale-leasebacks do not typically result in the consumption of the economic life of the asset), any gain realized will be recognized, regardless of the presence of a leaseback.
Gains made from the sale of the depreciated real estate asset can be immediately recognized as current revenue. The ability to recognize that revenue enables banks to capture the same as retained earnings. Retained earnings qualify for treatment as tier-1, common equity (CET1) capital. Finally, with the leaseback, banks must recognize the present value of the full term of the lease as a liability and record a right-of-use (ROU) asset equal to the lease liability.
And that is how you can unlock dormant capital in depreciated branches without diluting shareholder equity. Everyone wins.