Lease Accounting

FASB is changing lease accounting for everyone March 2015

Lease Accounting Update This past February, the US and international accounting boards (the FASB and IASB, respectively), have reached a consensus on the long-anticipated changes to lease accounting rules under US-GAAP and IFRS. Both Boards are now in the process of drafting these new standards, and they have publicly stated that they will be finalized and published this year. The official effective date of the new standards will be announced before the Boards publish their standards, and all signs and commentary point to a January 2018 effective date, with a comparative period requirement two prior years for most companies. Hence, after years of discussion and debate, it is now time for finance executives to focus on this issue. These changes will significantly alter how leases impact a company’s financial statements, but the impact of these changes will also affect many areas of corporate life outside of accounting, including corporate real estate, internal controls, information systems and operations. Some of the most critically important issues every CFO must understand include the following: 

Despite serious efforts to achieve a “converged” standard between FASB and IASB, the new leases standards are not converged. The most significant difference between the FASB & IASB’s new rules is the IASB’s new rules will use one “model” for accounting for all leases, while FASB’s new standards utilize a “dual model” approach, and those two models have very different financial statement impacts from one another.

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All leases – both existing and new – which have a maximum possible term greater than 12 months will be coming onto the balance sheet with a “Right of Use Asset” and a “Lease Liability”.

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By virtue of the fact the liability balances will almost always be greater than the asset balances, the impacts to balance sheet metrics are material, and include the following:

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Reduction to shareholder equity;

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Debt-to-equity and current ratios reduced;

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Reduction to regulatory capital, such as Tier 1 capital for banks.

The income statement impacts from a lease under the new standards can – and in many cases, will – look very different than under existing standards. o

For companies reporting under IFRS, all leases will have a front-loaded profile on the P&L, comprised of interest expense and amortization expense. Hence, as contrasted against existing operating lease treatment, profitability will be more adversely affected at the beginning of a lease term and improved at the end of it, while EBTIDA will improve throughout the lease term by virtue of the elimination of straight line rent expense for operating leases under current rules.

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For US-GAAP reporting entities, most real estate leases will have what appears to be straight line rent expense reported on the P&L, but which is actually comprised of interest and amortization expense (with the corresponding amounts required to be disclosed in the notes to the financials).

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Because of FASB’s “dual model” approach, it is also possible for US-GAAP preparers to end up with real estate leases having the same front-loaded, but EBITDA-friendly profile on the P&L as under IFRS. The importance of this is CFOs will want to ensure their leases are negotiated with everyone’s eyes open to the different P&L impacts possible under FASB’s new rules.

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In many instances, renewal options (and to a lesser extent, termination options), will significantly alter the P&L impact from a given lease, and those impacts could include either a worsening or an improvement of net income or EBITDA, or both.

Big Picture Details:

For all leases with a maximum possible term longer than 12 months, tenants will include such leases on their balance sheet on the principle that a “right-of-use” asset and a financial obligation have been created. This will apply to all entities that follow the FASB or the IASB standards regardless if they are public, private, or not-for-profit, and there is no grandfathering of existing leases. 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 lease liability and, subject to certain adjustments, the Right of Use Asset. The asset will reflect the tenant’s 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 initially be recognized in essentially the same way the capital lease is recognized under the current US GAAP. However, under FASB’s new rules the subsequent measurement of the asset for most real estate leases would differ from the way capital leases under current US GAAP are measured during the lease term. The New Classifications for Leases: Despite the FASB’s and IASB’s efforts to reach a consistent set of new lease accounting standards under both USGAAP and IFRS, in the course of finalizing these new standards the Boards diverged on whether to have one set of rules for all leases or to have different rules for different kinds of leases. Ultimately the IASB opted for a “single model” approach, in which all leases are referred to as “Type A” leases. Conversely, FASB’s new rules utilize a “dual model” approach which includes Type A leases but also “Type B” leases. Among the differences in the new rules from the FASB and the IASB, this is the greatest difference in their respective standards. Type A Leases: For Type A leases, the balance sheet and income statement impacts are consistent with the way in which a capital lease under existing standards impacts the financial statements. In other words, the lease liability is drawn down during the term of the lease based upon a combination of cash rent payments and interest expense on the outstanding liability, often referred to as the “effective interest method”. This means the interest expense hitting the P&L at the beginning of a lease term – when the outstanding liability is higher than it is later in the term – is greater than it is later in the term. The Right of Use Asset under a Type A lease is amortized off of the balance sheet via a straight line amortization method. Hence the asset is reduced by the same amount every month during the term, and that amortization expense runs through the P&L. The sum of the amortization expense and the interest expense represents the P&L

impact from the capitalized lease obligation. Type B Leases: As with a Type A lease, the lease liability under a Type B lease is drawn down during the term of the lease based upon a combination of cash rent payments and interest expense on the outstanding liability. This means the liability balance during the term of a Type B lease will be the same as it would be if that same lease were classified as a Type A lease. However, this is where the similarities between Type A and Type B leases end. The Right of Use Asset under a Type B lease is amortized off of the balance sheet during the term of the lease, but the way in which it is amortized bears no resemblance to Type A’s straight line amortization. Rather, it is a “plug” equal to the difference between Type B lease’s “straight line rent” expense and the interest expense for that period. Since interest expense will be decreasing as the liability is paid off during the term, this means amortization expense will be increasing at the same rate as the decrease in the interest expense. Moreover, while the expense reported on the income statement for a Type B lease is “straight line rent expense” (i.e., similar to today’s operating lease and “above the line” for EBITDA purposes), the interest and amortization components are required to be disclosed in the notes to the financial statements. So, while both Type A and Type B leases will be recorded on the balance sheet, the way in which they affect shareholder equity and the income statement differ significantly, with Type A leases having a worse effect on shareholder equity but a better effect on EBITDA results throughout the lease term. Similarly, Type A leases will have a worse impact on net income during the first half of a lease term, and then a better impact on net income during the latter half of the lease term as compared against the impact of the same lease if classified as a Type B lease. Lease Classification under US-GAAP: So which kind of lease do you have – Type A or Type B? The FASB has provided guidance around this question, and essentially replaces the “bright line” tests of existing capital lease tests to substitute them with more subjective or principles-based rules. In short, a lease will be classified as a Type A lease if: 

The lease term, as affected by any renewal or termination options which present the tenant with a significant economic incentive to exercise the option(s), represents the major part of the underlying asset’s remaining economic life;

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The present value of the lease payments during the lease term (as altered by the above-referenced options), is substantially all of the fair value of the underlying asset.

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The lease includes an option for the tenant to buy the building, and the tenant has a significant economic incentive to exercise that option.

The implications resulting from the classification of a lease under US-GAAP are far reaching and tenants will find they may be able to achieve certain financial results based upon the way in which the rents, term and renewal or termination options in their leases are structured and negotiated.

How will Amounts be Calculated? Rent - A tenant would initially measure the Lease Liability as the present value of the rent it pays during the lease term, as the term is affected either by termination options or renewal option periods for which the tenant has a significant economic incentive to exercise the option(s). The rent will be considered as the combination of: • The non-contingent rent (i.e., contracted base or fixed rent plus any rent increases based on an index); 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.) The calculation of the Right of Use Asset uses the Lease Liability as its starting point, but is subject to two further adjustments: • Deduct any lease incentives received from the lessor (e.g., tenant improvement allowances), and add • 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). Term – The non-cancelable period for the lease, together with the period(s) covered by options to extend the lease if the lessee has significant economic incentive to so exercise the option(s). Discount Rate – The discount rate used for calculating the Lease Liability, Right of Use Asset and interest expense is the tenant’s incremental borrowing rate as of the date of the lease commencement. The “incremental borrowing rate” is supposed to be based upon the rate the tenant would have to pay to borrow funds for a comparable period on an unsecured basis. Privately held companies will be able to utilize a “risk free rate”, such as comparable term US Treasury rates, if their “incremental borrowing rate” is not easily determinable. However, a risk free rate is expected to be less than the “incremental borrowing rate” and that has consequences for balance sheet metrics and potentially lease classification results. How Leases Will Appear in Financial Statements: 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.

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.

Other Lease Structures & Issues: Subleases 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). Sale-Leaseback Transactions A sale-leaseback transaction involves the sale (or transfer) of an asset and its subsequent leaseback by the seller. It has been proposed 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, rather than deferred and spread over the leaseback term as happens in most circumstances under current accounting rules. 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. Under FASB’s new rules a purchase option, even at future fair market value, will cause the transaction to be accounted for as a financing of the property rather than a sale and leaseback. What does this mean for corporate occupiers? 

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.

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The size of the Balance Sheet will increase.

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Some expenses will be accelerated and therefore increased in early years.

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Compliance with existing financial covenants will likely be harmed.

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Expenses charged to business units may change significantly.

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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.

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Corporations may want to re-evaluate their lease vs. ownership model and criteria.

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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.

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Leases of 12-18 years will become less attractive, especially for single tenant buildings, as they may have a Lease Liability (i.e., the present value of the rents) greater than the cost of the underlying property.

Getting Prepared: It is worth noting this is predominantly a real estate driven issue, as the overwhelming majority of the nominal value of all leases (i.e., equipment and real estate), is tied up in real estate leases. 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. Understanding, quantifying and, to the extent possible, mitigating the less desirable impacts from these new rules will require knowledge, resources and an action plan. Cresa has the knowledge and resources, both in terms of people and technology, to help companies implement their respective action plans to deal with these new standards. We have observed the firms having the most success in preparing for these new accounting rules all have a plan that includes the following four steps: Step One:

Conduct a strategic review of your lease portfolio in order to (A) begin building a framework around how your firm will deal with the more subjective issues in these new standards, including topics related to “significant economic incentives” in renewal and termination options, evaluating a property’s remaining economic life, and (B) quantify and understand the way in which a representative sample of your leases would be reflected on your financials under these new rules.

Step Two:

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 Three: Get internal operating teams and systems aligned for functional integration and expanded workload. Step Four:

Update corporate strategy regarding financing decisions, operating requirements, and real estate decision making.

About the Author

Brant Bryan Principal Brant Bryan is the leader of Cresa Capital Markets, and specializes in creative and efficient financing of facilities through leases, purchases, joint ventures and other financial structures. 972.713.4000 main 972.250.1618 dd 214.914.8279 cell [email protected]