The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) appears to be moving forward with lease accounting rule changes meant to curb abuses and errors caused by off-balance accounting. Tenants very often use leases as a means of financing operations, but loopholes in the system have allowed for many of those hedged bets to be placed off the balance sheet, which diminishes transparency and can create volatility. Moving those debts back onto balance sheets is expected to increase corporate debt by the trillions, so it’s extremely important for tenants to understand the new accounting standards. For more on this, continue reading the following article from Brant Bryan at Cresa Capital Markets.
In 2004 the Securities and Exchange Commission (SEC) estimated that off-balance sheet leasing commitments by SEC registered firms totaled approximately $12.5 trillion dollars. Leasing is big business.
In May of 2013 the US and International Accounting Boards (the FASB and IASB) issued Revised Exposure Drafts on proposed changes to the accounting for leases that will significantly change how lessees and lessors account for and report leases in their financial statements. The Boards are seeking greater transparency from lessees regarding the financial commitments they make and their operating cash flows. From lessors they are seeking greater transparency about the nature of financing agreements being entered into, as well as the residual values of their assets.
After lengthy discussion, the Boards made extensive modifications to their 2010 lease accounting proposals. Some notable changes from the 2010 proposals include:
- The introduction of a dual-model approach for lessee accounting that would change the pattern and presentation of lease expense for many leases
- Significant revisions to the lessor accounting model
- New lease classification tests that would apply to lessees and lessors
- A new way of estimating the lease term
- Changes to the accounting for most variable lease payments
The majority of the changes now proposed are very likely to become new standards. The impact of these changes will effect many areas of corporate life: real estate, finance, information systems, operations, and of course, accounting.
The proposal has not been finalized, and comments on the proposals are due by September 13, 2013. A final standard is to be issued in early 2014. The new standards would be effective no earlier than annual reporting periods beginning on January 2017, but would include a two year look back.
Under the new standard, leases will be considered a “Right-of-Use.”
For all leases longer than 12 months, both Lessees and Lessors will include such leases on their balance sheet on principles that a “right-of-use” has been granted and a financial obligation has been created. There will be no grandfathering. This will apply to all entities that follow the FASB or the IASB standards regardless if they are public, private, or not-for-profit.
Lessees will now show both a new asset and a new liability. The asset will reflect their right of use for the leased property and the liability will reflect their obligation to make lease payments. The right-of-use (ROU) asset and lease liability would be recognized in essentially the same way the capital lease is recognized under the current US GAAP. However, the measurement of the asset and liability would differ from current US GAAP.
In short, all non-contingent rent (the rent that is committed and realistically expected to be paid) will be calculated as a present value as of the lease commencement date. That present value will be the amount of the Right-of-Use asset and liability.
The New Classifications for Leases
All lessees and lessors will categorize leases as either a Type A lease or a Type B lease. Generally, Type A leases are equipment and Type B leases are real property. In Type A leases, income and expense will be accelerated, consistent with the income statement impact under GAAP for other financing transactions. In Type B leases, the income statement impact will generally be straight-lined.
For leases accounted for under the straight-line approach, the amortization of the Type B asset would be calculated as the difference between the total straight-line lease expense (total undiscounted lease payments – subject to certain adjustments – divided by the lease term) and the interest expenses related to the lease liability for the period. The expense recognition pattern for leases accounted for under the straight-line approach must be straight-line, regardless of whether this is the pattern of consumption for the underlying asset.
If the underlying asset is property (defined as land or a building, or part of a building, or both) the lease would be classified as a Type B lease unless one or more of the following criteria are met, in which case the lease would be classified as Type A lease:
1) The lease term is for a major part of the underlying asset’s remaining economic life;
2) The present value of the lease payments is substantially all of the fair value of the underlying asset.
How will Amounts be Calculated?
Rent – A lessee would initially measure the right-of-use asset as the present value of the rent it expects to pay during the lease term. The rent will be considered as the combination of:
- The non-contingent rent (fixed rent plus rent based on an index); plus
- Any initial direct costs incurred by the lessee (i.e., costs directly attributable to negotiating and arranging a lease that would not have been incurred without entering into the lease – e.g., commissions and legal fees); plus
- Any termination penalties or residual guarantees that are to be paid; plus
- Any option payments that the lessee has significant economic incentive to exercise; minus
- Any portion of the rent that is considered embedded operating costs (such as CAM, utilities, taxes, insurance, services, etc.); minus
- Any lease incentives received from the lessor.
A lessee will need to re-measure what is committed rent if the lessee has any change in the lessee’s assessment of what their lease payments will be and /or discount rate is (see discussion on discount rates below).
- A change in the lease payments could occur due to a change in the assessment of whether the lessee has a significant economic incentive to exercise a lease term or purchase option, a change in estimated payments to be made under a residual value guarantee, or a change in an index or rate on which variable lease payments are based.
- Any amount of re-measurement attributable to changes in an index or rate that relates to the current period would be recognized in profit or loss; and
- If the carrying amount of the right-of-use asset were reduced to zero, any remaining amount of re-measurement would be recognized in profit or loss.
- A reassessment of whether the lessee has a significant economic incentive to exercise a lease term or purchase option would be required upon a change in contract-based, asset-based, or entity-based factors that affected the previous assessment of whether to include in lease payments amounts the lessee would be required to pay if it exercised a lease term or purchase option. So extensions of a business services contract, increased investment in a facility, or changes in legal matters might all cause a reassessment. Conversely, a change in market-based factors (such as market lease rate for a comparable asset) would not, in isolation, trigger a reassessment of whether the lessee has a significant economic incentive to exercise a lease term or purchase option.
Term – The non-cancelable period for the lease, together with the period(s) covered by options to extend or not to terminate the lease if the lessee has significant economic incentive to so exercise.
Discount Rate – The discount rate used for lessees should be the rate the lessor charges the lessee if this rate is available. If that rate is not available, which is generally expected to be the case, the lessee should use its incremental borrowing rate as of the date of the lease commencement. Lessors should use the rate they charge the lessee – the rate implicit in the lease or the yield on the property.
The RED also discusses circumstances in which an entity should reassess the discount rate. Specifically, an entity should perform such a reassessment when there is a change in the (1) lease term, (2) conclusion about whether a lessee has a significant incentive to exercise an option to purchase the underlying leased asset, or (3) referenced rate, if variable lease payments are based on that rate. Nonpublic entities would be allowed to make an accounting policy election to use the risk-free discount rate for all leases.
How Leases Will Appear in Financial Statements
The Balance Sheet –
- Right-of-use assets shown separately from other assets;
- Lease liabilities shown separately from other liabilities;
- Right-of-use assets arising from Type A leases separately from those arising from Type B leases; and
- Lease liabilities arising from Type A leases separately from those arising from Type B leases.
The Income Statement –
- For Type A leases, a lessee would present the interest on the lease liability separately from the amortization of the right-to-use asset; and
- For Type B leases, a lessee would present the interest on the lease liability together with the amortization of the right-to-use asset as part of the single lease expense amount.
- Payments arising from Type B leases would be classified as operating cash flows.
For real property leases (Type B), the lessor would apply an operating lease model similar to operating lease accounting under current GAAP in which the lessor would continue to recognize the underlying asset and would recognize the lease payments as income over the lease term generally on a straight-line basis. No lease receivable or residual asset would be recorded under the operating lease model because the lessor would not derecognize the underlying asset.
An intermediate lessor (such as a tenant who is subleasing to a subtenant) would classify and account for the primary lease in accordance with the lessee accounting proposals. Similarly, it would classify and account for the sublease in accordance with the lessor accounting proposals. To determine the classification of the sublease, the intermediate lessor would consider the underlying asset in the primary lease.
An intermediate lessor will present both the primary lease and the sublease on a gross basis in the income statement and statement of cash flows. So they should show the accounting presentation for both the lessee (for the primary lease) and lessor (for the sublease).
A sale-leaseback transaction involves the sale (or transfer) of an asset and its subsequent leaseback by the seller. The Exposure Draft proposes that if the requirements for the recognition as a sale are met, then a sale and leaseback of the underlying asset would be recognized; otherwise, the transaction would be accounted for as a financing.
For a sale, the Seller-Lessee will recognize a gain or loss on sale transaction based on the sale price, assuming the sale price and leaseback payments are at market rates. This gain or loss will be fully recognized in the year of the sale. Seller-Lessees shall disclose information on their sale-leaseback transactions including the principal terms of the arrangements, as well as any gains or losses recognized. Purchase options at market do not cause any change in the reporting of the transaction.
In build-to-suit lease arrangements, the lessee typically is involved with the construction of the asset. Under current guidance on accounting for build-to-suit arrangements, the lessee is sometimes deemed the accounting owner of the leased property. However, the new standards will not retain the current guidance.
The RED proposes payments made by the lessee in connection with the construction of the asset would be accounted for in accordance with the other applicable US GAAP (e.g., inventories). Any payments made by the lessee for the right to use the asset (regardless of whether they are made during the construction period) would be accounted for as lease payments. In situations in which the lessee controls the underlying asset (e.g., the land on which the leased property will be constructed) before lease commencement, sale-and-leaseback accounting should be applied.
What does this mean for corporate occupiers?
- Internally, corporations need to review and update lease databases and technology systems to capture and calculate all the data to be required for the new reporting standards. This will need to be a joint effort of real estate, information technology, finance, and accounting groups.
- The Financial Statements of corporations will significantly change including:
- The size of the Balance Sheet will increase
- Some Expenses will be accelerated and therefore increased in early years
- Compliance with existing financial covenants will likely be harmed
- Expenses charged to Business Units may change significantly
- No changes to corporate credit ratings or borrowing costs are expected. The rating agencies have said they fully understand leasing and how corporations use leases, so a change in way the leasing is presented will not change the way the rating agencies underwrite the companies that use leasing.
- Corporations may want to re-evaluate their lease vs. ownership model and criteria
- More attention will be paid to lessor financing, especially in single tenant buildings. In single tenant buildings, the cost of funds should become more relevant than rent per square foot
- Leases of 12-18 years will become less attractive, especially for single tenant buildings, as they may have a Right-to-Use asset value (the present value of the rents) greater than the cost of the underlying property.
To Get Prepared –
Step One: Get Systems and Technology upgraded so you capture the data needed. This will be a joint effort by corporate teams from real estate, information technology, equipment leasing, finance, and accounting.
Step Two: Get internal operating teams and systems aligned for functional integration and expanded workload.
Step Three: Update corporate strategy regarding financing decisions, operating requirements, and real estate decision making.
To sum it up – changes in lease accounting standards are coming, but you have time to prepare. The final result will likely look a great deal like the Revised Exposure Draft issued in May 2013, but won’t be fully implemented until 2017. Corporate occupiers of space will want to prepare for these changes, which will be significant, by understanding their lease obligations and making sure they have accurate data. Tenants who utilize long term single tenant leases may find that the rule changes impact them substantially and especially will want to consider different strategies of negotiating such leases, using alternative lease structures, and in some occasions opting to purchase their facilities.
This article was originally published on cresa.com.