New lease accounting rules could put title insurance and escrow industries in California on the wrong side of their state regulator.
But state lawmakers have developed some remedies.
Two bills await Gov. Gavin Newsom’s (D) signature to ensure these companies don’t violate liquid-asset requirements once they put liabilities from renting office space and equipment on their balance sheets for the first time.
The issue: state regulators require title insurance and escrow companies to maintain a certain amount of liquid assets after accounting for all liabilities. Under the Financial Accounting Standards Board’s new lease accounting standard, lease obligations are considered liabilities for financial reporting. Adding more liabilities to companies’ books could force some title insurance and escrow businesses out of compliance.
“If lease obligations are going to come onto the balance sheet, it could make a mess of that liquid asset requirement,” said Michael Haas, partner at Morton Alan Haas & Co. in Burbank. “Some clients have enough cash where it’s not going to matter, but there are a bunch where it does.”
California regulations require an escrow agent to maintain a tangible net worth of $50,000, including liquid assets of at least $25,000 in excess of current liabilities.
An escrow company with five rented branches could potentially have to account for $1 million in new lease obligations under the new rules. The accounting change could put such a company well outside the liquid assets requirement, said Jennifer Felten, owner of RELAW, APC, a real estate law firm in Westlake Village.
Similarly, David Wilson, partner at Grant Bennett Associates, an accounting firm in Sacramento, said he put together sample financials for a healthy title underwriter with three rented offices. Under the new lease accounting standard, the company would be out of compliance by $100,000.
“No one was thinking about this,” Felten said. “FASB rules weren’t, ‘Oh, we’re going to get independent escrow companies and title insurance companies in California’.”
A.B. 412, which passed the California Senate Aug. 26 and the Assembly on Aug. 30, would amend the state’s financial code to exclude a liability from an operating lease obligation from for purposes of establishing tangible net worth for escrow companies.
Underwritten title companies, which in California prepare title searches, title examinations, and title reports, must maintain current assets of at least $10,000 in excess of its current liabilities.
A.B. 295, which passed the Senate on Aug. 12 and the Assembly on Aug. 22, would amend the state’s insurance code to exclude operating leases from a company’s liabilities for the purposes of meeting the liquid asset requirements for underwritten title companies.
FASB sets accounting rules and doesn’t enact regulations. That said, many regulations are tied to how companies account for their finances under the board’s U.S. generally accepted accounting principles.
Sometimes, regulations need to change after a shift in accounting rules, FASB Vice Chairman James Kroeker said.
“This is the ideal way that it works. If those who regulate feel the regulations need to adjust, they do that,” Kroeker said.
FASB published its lease accounting standard after years of debate about how to make company balance sheets more transparent about their financial condition.
For decades, companies had to record leases as liabilities only if they met the definition of a finance lease, an arrangement that essentially transferred the asset to the renter at the end of the lease term. Companies were able to structure their leases so they didn’t meet the definition of this type of lease and were able to keep the rental agreements off their balance sheets—away from the eyes of investors and creditors.
Investors and regulators—particularly in the post-Enron era—complained that a company renting its storefront space had just as much money tied up in rent as one that had mortgaged them. With no on-balance sheet details about these liabilities, investors were forced to make rough estimates.
Public companies started following the new accounting this year. Private companies were expected to comply in 2020, but FASB recently issued a proposal allowing them an additional year.
Gov. Newsom has until Oct. 13 to sign or veto AB 412. He has until Sept. 9 to sign or veto AB 295, the governor’s press office said. The governor hasn’t taken a position on either bill, although the Department of Finance in its analysis of A.B. 412 opposed the bill, saying liquidity requirements could be addressed through regulations. In addition, the analysis said the proposed exclusion of leases to determine liquidity would provide the department “an incomplete view of an escrow company’s viability.”
“I believe commonsense will prevail,” said Claire Bartos, president of the Escrow Institute of California.