Lease Accounting Changes
LEASE ACCOUNTING CHANGES What It May Mean To Your Organization October 26‐27, 2011 International Conference of Shopping Centers U.S. Shopping Center Law Conference
Lease Accounting Changes
Faculty
z Kim Marie Boylan, a partner at White & Case LLP in the tax department. She has an LLM from Georgetown University Law Center in Tax. She specializes in tax controversy, transfer pricing, and accounting and tax policy matters. She is a Certified Public Accountant and frequent lecturer and author on tax and accounting issues. Kim has testified on behalf of clients before the United States Treasury Department, Internal Revenue Service, and the Financial Accounting Standards Board. z Thomas F. Kaufman, a partner at Hunton & Williams LLP in the Capital Finance group with an MBA from The Wharton School at the University of Pennsylvania. Tom specializes in complex and structured financing most often involving real estate. He is an adjunct professor at Georgetown University Law Center, where he got his JD, and has been a lecturer at Wharton, Georgetown and George Washington University business schools.
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Lease Accounting Changes
Contacts
Kim Marie Boylan White & Case, LLP 701 Thirteenth Street, NW Washington, DC 20005 (202) 626‐3685
[email protected]
Thomas F. Kaufman Hunton & Williams LLP 2200 Pennsylvania Avenue, NW Washington, DC 20037 (202) 955‐1604
[email protected]
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Lease Accounting Outline Changes 1. Why should you care about lease accounting? 2. What is the current timeline for lease accounting changes? 3. How are leases accounted for today? 4. Proposed changes to lease accounting. 5. Specific significant areas of concern –discussion of current rules, original exposure draft, tentative decisions, new exposure draft 6. Implications of the proposals – what specific ramifications will the accounting changes have on companies? 7. What should you be doing now? 8. Questions?
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Lease Accounting Changes 1. Why Should You Care About Lease Accounting? It cures insomnia It affects perceived returns on investment It affects who owns real estate It impacts financial covenants and many other areas that implicate the legal department – Who Controls United States Accounting?
– – – –
• Financial Accounting Standards Board (FASB) • Securities & Exchange Commission (SEC)
– Codification of Accounting Rules • www.fasb.org
– Why change the rules? • Concern Lease Liabilities Not Shown on Balance Sheet – Inhibits Comparability and Transparency • Convergence with International Standards – International Accounting Standards Board (IASB) – International Financial Reporting Standards (IFRS)
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Lease Accounting Changes •
What is the Current Timeline For Changes to Lease Accounting Rules March 2009 – Discussion Paper August 2010 ‐ Exposure Draft March 2011 ‐ Significant Changes to Decisions September 2011 ‐ Further Decisions and Changes First Half 2012 ‐ Second Exposure Draft with likely 120 day comment period – Effective Date ‐ Originally January 2013, but now unclear – – – – –
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Lease Accounting Changes •
How are Leases Accounted For Today? – – – –
SFAS 13 issued in November of 1976 Subject to significant, numerous interpretations US model differs from model used internationally Two models under existing US rule • Operating leases – P&L only • Capital leases – recorded on balance sheet and P&L
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Lease Accounting Changes Capital Lease reported on balance sheet if: – – – –
Lessee has ownership at lease termination Lease term exceeds 75% of asset life Bargain price purchase option for lessee at termination Present value of lease payments exceeds 90% of fair market value of asset
Otherwise operating lease not reported on balance sheet – Rental income/expense shown in income statement Very rare for lease of real estate to qualify for capital lease treatment
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Lease Accounting Changes • Proposed changes to lease accounting – Will impact both landlord and tenant • Will change financial statements • No grandfathering of existing leases – all leases affected
– Focus on reducing “off balance sheet” transactions – Estimate upwards of $1 trillion in lease transactions for public companies alone – Perceived arbitrary nature of criteria used to determine operating vs. capital under existing rules – Convergence with international standards – Rent income/expense replaced by interest and amortization – Separately account for lease and non‐lease components including services and contracts
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Lease Accounting Where are We Headed – Proposed Rules Changes • Specific significant areas of concern – discussion of current rules, original exposure draft, tentative decisions, new exposure draft – “Off balance sheet” lease financing will be a thing of the past – Substantially all leases will give rise to the recordation of an asset and liability for both the lessee and lessor – For lease “heavy” entities in particular, will require new processes and financial reporting controls – Will require use of judgment and estimates not present in existing rules and require some level of ongoing evaluation
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Lease Accounting Proposed Tenant Accounting Changes – Tenants will apply the “Right of Use” model – Record an asset representing the right to use the asset • Day 1 – Record at initial cost equal to the value of liability plus direct lease costs • Day 2 – Amortize over shorter of lease life or useful life of the asset. Recorded as amortization expense not rent expense. Also subject to impairment testing
– Record a liability representing obligation to pay for the right to use the asset • Day 1 – Valued at PV of lease payments • Day 2 – Recorded at amortized cost using effective interest method similar to amortizing mortgage loan
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LeaseProposed Tenant Accounting (cont’d) Accounting Changes – Lease payments using present value, include • Amounts expected to be paid under residual value guarantees • Variable lease payments expected to be paid • Termination penalties and payments expected to be paid
– Lease term and payments estimated as of commencement • Use expected renewals in determining term
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Lease Accounting Proposed Tenant Accounting (cont’d) Changes – Determine discount rate for present value • Lessee uses implied rate charged by lessor, when available, or lessee’s incremental borrowing rate
– Initial direct cost incurred by lessee included in asset valuation – Lease incentives deducted from asset valuation
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Lease Accounting Proposed Tenant Accounting (cont’d) Changes No more rent expense! Amortize value of liability to make lease payments Incur interest cost on amortized value of leased asset Right of use asset will be subject to existing standards for asset impairment – Lease term re‐assed when a significant change to factors influencing economic incentives to exercise an option to extend or terminate a lease – – – –
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Lease Accounting Proposed Tenant Accounting Changes – Balance Sheet • Right of use asset in property, plant and equipment, but separate from non‐leased assets • Liabilities to make lease payments separate – Income Statement • Amortization of right of use asset separate • Interest expense separate
– Statement of cash flows • Cash flows, treated as financing activity and separately disclosed
– Transition • Apply rules to remaining lease payments and terms
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Tenant Lease Accounting – Example 1
Lease Accounting Changes
– Example 1: ABC leases office space from XYZ Lease term – 10 years Annual rent ‐ $1,000,000 Useful life of building – 40 years ABC incremental borrowing rate – 7.70% Today: ABC expenses $1,000,000 per year New rule” ABC lease asset = present value of rent = $6,800,000 Liability increases by $6,800,000 • 1st year:
• • • • • •
– Depreciation of $680,000 – Interest expense of $523,600
– Operating Lease 1st year cost ‐ $1,000,000 – Capitalized lease 1st year cost ‐ $1,203,600
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Lease Accounting Tenant Lease Accounting – Changes
Example 2
– Example 2: ABC leases office space from XYZ • • • • •
Lease term – 2 years Annual rent ‐ $1,000,000 ABC incremental borrowing rate – 7.70% Operating Lease 1st and 2nd year cost ‐ $1,000,000 each year Capitalized lease 1st and 2nd year cost
2 Yr Lease
30 Yr Lease
Depreciation Yr 1
$ 895,313
$ 386,136
Interest Yr 1
$ 137,878
$ 891,974
Total Yr 1
$1,033,191
$1,278,110
Total Yr 2
$ 966,809
$1,248,377
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Lease Accounting Proposed Landlord Accounting Changes – Landlord/lessor requirements proposed to achieve symmetry with tenant accounting (math may not be the same however) – Hybrid approach depending on whether lessor retains exposure to significant risks and benefits • Performance obligation approach will apply when significant exposure is retained • Derecognition approach
– Under either approach, landlord records an asset for right to receive rental payments – Decisions after Exposure Draft may mean simplified single approach for landlord more like derecognition approach
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Lease Accounting Proposed Landlord Accounting Changes Performance Obligation Approach – Day 1 accounting • Underlying asset remains on the balance sheet • Lease receivable (asset) – represents right to receive lease payments, recorded at present value (PV) of probability weighted cash flows over expected lease term, use rate implicit in the lease for PV • Obligation to permit asset use (liability) – represents obligation to provide asset, generally recorded in amount equal to the lease receivable
– Day 2 accounting • Lease payment applied to interest (generally determined by imputing interest on the amortized value of the lease receivable at the inputted interest rate in the lease.) • Balance of lease payment applied to amortization of lease receivable (generally in a straight line over lease term).
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Lease Accounting Proposed Landlord Accounting Changes Derecognition Approach – Day 1 accounting • Partial derecognition of underlying asset. Record lease receivable and residual interest in underlying asset. Could result in Day 1 gain or loss recognition • Lease receivable – representing right to receive payments, measured based upon PV probability weighted cash flows over expected lease term, use rate implicit in the lease for PV • Residual interest – representing landlord’s retained interest
– Day 2 accounting • Lease rent – applied to interest on lease receivable and amortization of lease receivable • Residual interest – not re‐measured but subject to impairment analysis
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Lease Accounting Judgments and Estimates Changes Computation variables/estimates – Lease term • Inclusion of options to renew or terminate included based more likely than not evaluation
– Lease payments • Inclusion of increasing minimum/contingent payments based on probability weighted analysis of potential outcomes
– Discount rate in PV calculation • For tenants – tenant’s incremental borrowing rate • For landlords – rate implicit in the lease
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Lease Accounting Judgments and Estimates Changes – Tenants vs. Landlords • Although variables similar, may rely on different information and may draw different conclusions about lease terms, probability weighted lease payments (contingent rents, etc.) and residual values • Discount rate used in PV calculations different by rule • Symmetry is a goal but not a mandate
– Others • Purchase options • Residual values
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Lease Accounting Potential Business Impacts Changes • Implications of the proposals – what specific ramifications will the accounting changes have on companies? – Tenants • Increase in total assets and total debt for tenants • Potential impact on borrowing covenants • Financial Metrics – Book and tax timing differences related to amortization rent deductibility and contingent rents – Return on assets changes – Interest coverage changes – Changes in weighted – average cost of capital/hurdle rates – Debt and equity ratios
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Lease Accounting Potential Business Impacts Changes – Landlords • No impact on cash flows • Potential impact on real estate underwriting • Similar impact on balance sheet and income statement as for lessees under Performance Obligation approach less so for Derecognition • Key for landlords will be understanding the business intention of leasing the asset to determine if significant risks and rewards have been retained
– Other Considerations • Impact on non‐GAAP measures – EBITDA, FFO, etc? • Increase in operating measures such as EBITDA and FFO could trigger employee compensation under current compensation arrangements • Impact on business combination reporting – “significant tests” used in evaluating potential and actual business combinations • Potential tax accounting method changes
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Lease Accounting Potential Business Impacts Changes – Tenant/Landlord behavior • Tenants may seek to negotiate lease terms that serve to reduce the value of the recorded liability – Shorter lease life (option years generally included) – Gross vs. net leases • Reaction from the credit markets will be critical • Buy vs. lease • Re‐evaluate benchmarks for employee compensation • May be more difficult and take longer to negotiate leases given financial statements implications to tenants and landlords alike • Impact on specific industries • Application to all leases at point of adoption • European experience with IASB has to some extent already dealt with this
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Lease Accounting What Changes • What should you be doing now
to do?
– Exposure Draft Issued August 17, 2010 • http://www.fasb.org/home
– – – – –
Final rule in 2012? Implementation in 2013‐2014? Evaluate impact on financial statements Evaluate impact on capital structure and strategy Evaluate/renegotiate existing agreements because of financial metrics (debt agreements, compensation agreements, joint venture agreements)
– Evaluate own /lease and sale‐leasebacks
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Lease Accounting Changes •
Questions??????
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