Presentation on theme: "The Changing Landscape of Lease Accounting A joint IASB/FASB project Alvin Wade Audit Partner May 26, 2011."— Presentation transcript:
1 The Changing Landscape of Lease Accounting A joint IASB/FASB project Alvin Wade Audit Partner May 26, 2011
2 What is the catalyst behind the proposed changes? The Sarbanes-Oxley Act required the SEC to do a study of off-balance sheet transactions.Lessee off-balance sheet operating leases were cited as a major financial reporting deficiency.The FASB and the International Accounting Standards Board (IASB) have formed a joint project to converge world-wide accounting rules (including lease accounting).
3 What is the primary objective of the proposed changes? To require all leases to be recognized on the balance sheet of lessees and lessors
4 Originally proposed impact on the lessee Required to record an asset representing the right to use the asset over the lease termRecord a liability for the obligation to pay rentalsThe recorded asset and liability require the lessee to estimate certain future events and conditions such as renewal options, contingent rents and incremental borrowing rate
5 Types of arrangements scoped out include: Leases of intangible assetsLeases to explore for or use natural resourcesLeases of biological assetsContracts that represent the purchase or sale of the underlying asset
6 Changes to proposed EDBased on nearly 800 comment letters – the boards re-deliberated the following:Lease termVariable lease paymentsIncome and expense recognition patternLease definition
7 Definition of lease term Originally proposedThe longest possible lease term that is more likely than not to occur (greater than 50%)Currently proposedThe non-cancellable period, plus any options where there is a significant economic incentive to extend
9 Variable lease payments (contingent rents, termination penalties) Originally proposedAmounts were to be estimated under various scenarios and included as part of your assets and liabilities recognizedCurrently proposedHigher recognition threshold established to include certain performance based contingent rents in definition of lease payments
10 Income and expense recognition pattern Originally proposedFront end loaded expense and income recognitionCurrently proposedNo change – consideration was being given to allowing straight line recognition of lease income and expense for leases not having a significant financing element.
11 Comparison of current treatment to the proposed standard A simple example:Lease Term - 5 years, annual rent is $20,000 per yearLessee's incremental borrowing rate = 8%
12 Comparison of current treatment to the proposed standard (continued) A simple example:Current TreatmentProposed New StandardDifferenceYearLease ExpenseDepreciationInterestTotal1$20,000$14,706$7,550$22,256$(2,256)220,00014,7066,52021,226(1,226)35,40020,106(106)44,20018,9061,09452,80017,5062,494$100,000$73,530$26,470$0
13 Comparison of current treatment to the proposed standard (continued) Front ends lease expense as straight-line depreciation and imputed interest replace straight line rent.
14 Proposed standard requires estimate of lease term and payments Renewal optionsContingent rentsIncremental borrowing rate
15 Renewal options/contingent rents Base term (years 1-5) $20, % of salesFirst renewal (years 6-10) $25, % of salesSecond renewal (years 11-15) $30, % of salesIBR-8%
16 Assume:. -Will exercise only first renewal Assume: -Will exercise only first renewal -Contingent rents = $500 year 1 and grow $20/yearCurrent TreatmentProposed New StandardDifferenceYearDepreciationInterestTotal1$23,000$15,091$12,394$27,485$(4,485)223,02015,09111,72126,812(3,792)323,04010,99026,081(3,041)423,06010,19625,287(2,227)523,0809,33524,426(1,346)623,1008,21423,305(205)723,1206,76921,8601,260823,1405,20120,2922,848923,1603,50518,5964,5641023,1801,66516,7566,424$230,900$150,910$79,990$0
17 Business implications of proposed model Impact on loan covenants and financial ratiosdebt to equity ratiosinterest coverageImpact on buy vs. lease decisionsImpact on standard lease terms (may want shorter leases)Tenants may want to renegotiate existing long-term leases
18 Impact on landlord (lessor) Required to recognize leases on their balance sheetDesire symmetry between lessor and lesseeSeveral approaches being consideredPerformance obligation approachDerecognition approachHybrid model
19 Performance obligation Lessor records lease receivable based on estimated lease term and contingent rents receivedPayments discounted using implicit interest rate in the leaseInterest income recognized on the effective interest methodLiability recorded for obligation to provide the use of the space and amortized over life of the lease
20 Comparison of current treatment to the proposed standard A simple example:Lease Term - 5 years, annual rent is $20,000 per yearImplicit interest rate = 8%
21 Comparison of current treatment to the proposed standard A simple example:Current TreatmentProposed New StandardDifferenceYearLease IncomeRental IncomeInterest IncomeTotal1$20,000$14,706$7,550$22,256$(2,256)220,00014,7066,52021,226(1,226)35,40020,106(106)44,20018,9061,09452,80017,5062,494$100,000$73,530$26,470$0
22 Derecognition modelLessor would partially derecognize the underlying assetResidual interest in investment property and lease receivable will be recorded to the B/S as separate assets
23 Status of proposed project Boards continue to deliberate final revisions to the proposed standardChanges needed to lessor accounting will be considered as a separate project or later as part of this projectFinal standard still targeted for 2011
25 The New Lease Accounting Standards The Real Estate Perspective
26 The New Standards (as of April 21, 2011) A Brief OverviewKey differencesNo More Operating LeasesBalance Sheet ImpactFAS 13: Operating Lease – It is off the balance sheetFAS 13: Capital Lease – On balance sheetNew Standard: All leases on balance sheet, and impact for some leases is larger than under FAS 13 Capital Lease.Renewal Options – If “significant economic incentive”Contingent Rents – If “disguised”“Short term” leases not capitalized (but active debate at May meeting)
27 The New Standards (as of May 20, 2011) A Brief OverviewKey differencesIncome Statement ImpactFAS 13: Operating Lease – Straight line rent over termFAS 13: Capital Lease – Amortization of asset (PV of rent at lessee’s incremental borrowing rate) + Interest expense on remaining liability.New Standard:Boards Must Like The Texas Two-Step …To know what’s happening you need a calendar
28 The New Standards (as of May 20, 2011) A Brief OverviewKey differencesIncome Statement ImpactAugust 2010:Exposure Draft –All leases the sameAmortization + Interest; Front Loaded P&L profileApril 2011:Revised Proposal Approved by Boards: 2 kinds of leases:“Finance Lease” – ED Method“Other Than Finance Lease” – Calculated on straight line with interest component, but presented as “rent expense” on P&LMay 19, 2011:Boards agree to reverse course – back to ED Method / no classification
29 The New Standards (as of May 20, 2011) A Brief OverviewKey differences - OptionsRenewal & Termination Options Included In Calculations:FAS 13: “Reasonably assured” = rarely triggeredNew Standards:Original Exposure Draft : “More likely than not”Revised Proposal: Include if “Reasonably certain” based on the presence of a “significant economic incentive” to renew or terminate… so much for objective criteria …Is 95% of FMV renewal a “clear economic incentive”?High value T.I.s with remaining life would be thoughCritical / strategic business use for spaceEasier to trigger for Lab, Manufacturing, SCIF and custom space
30 The New Standards (as of April 21, 2011) A Brief OverviewKey differences – Contingent RentsContingent Rents Included In Calculations:FAS 13: CPI, Yes; Other Contingent Rents, No.New Standards:Original Exposure Draft: All included based upon probability weighted outcomes (a.k.a. the crystal ball method)Revised Proposal:CPI based on “spot” rate as opposed to probablePercentage RentOnly if “disguised minimum rent”Based on expected outcome / estimate
31 The New Standards (as of May 20, 2011) A Brief OverviewKey differences – Executory CostsExecutory Costs:FAS 13: All are excluded for both capital and operatingNew Standards:Original Exposure Draft: Executory costs replaced with “Distinct Service Components”, not same as Executory Costs“Distinct service components” not capitalized as asset / liabilityNon-distinct service components – notably property taxes and insurance – to be capitalizedRevised Proposal:Separate “lease” and “non-lease” componentsNot via Rev. Rec. / “Distinct Service Components”“Observable prices”
32 New Lease Accounting Rules Executory / Non-Lease ComponentsCombo of Front Loaded P&L + Executory / Non-LeaseRevised proposals make current and future executory treatment the sameEffect on tenants with gross leasesMost have not removed base expenses from FAS 13 rentConstant base amounts and straight line rent have same P&L.Not the case with new standards due to front loading.Impact: More work / calculations to avoid overstating asset and liability.Creates added incentive for tenant to ensure base year costs are as high as possible because:Reduces add’l rent expense,Keeps more $ off balance sheet
33 Specific Issues To Address Determining the Term: “Significant Economic Incentives”
34 New Lease Accounting Rules Impact of Renewal / Termination OptionsThe Case of One LeaseKey Assumptions For Exercise:100,000 RSFTenant’s Incremental Borrowing Rate – 7.0%10 Year Term, with one 10 Year Renewal OptionRental Payments / Year / RSFInclude taxes + insurance, exclude “Distinct Service Components”Annual RentYears 1 – 3: $40 / RSFYears 4 – 6: $45 / RSFYears 7 – 10: $50 / RSFRenewal: FMV but not less than $50 / RSF
35 New Lease Accounting Rules Impact of Renewal / Termination OptionsRenewal OptionsDetermining “significant economic incentive”.Are renewal options truly exercised in most cases?To what extent will income statement sensitivity drive renewal decisions?Need auditable process / mechanism by which renewal “decisions” can be tested.Second guessing of renewal determination by competing interestsA few “what if?” examples:
36 New Lease Accounting Rules Impact of Renewal / Termination OptionsBaseline Scenarios #1: No Signficant Economic Incentive
37 New Lease Accounting Rules Impact of Renewal / Termination OptionsBaseline Scenario #2: “Significant Economic Incentive” Exists
38 New Lease Accounting Rules Impact of Renewal / Termination OptionsBaseline Scenario #3: No “Significant Economic Incentive”, Lease Renewed
39 … No Incentive At LCD, But At End of Year 5 Incentive Materializes? Real World ConsequencesForget Baseline: What Happens When …… No Incentive At LCD, But At End of Year 5 Incentive Materializes?
40 Real World Consequences Forget Baseline: What Happens When …?Impact of Decision: Immediate Losses, Aggregate “Wash”, NPV is Loss
41 New Lease Accounting Rules Example Of Unintended ConsequencesImpact On Lease Negotiations – Death of “Blend & Extend” Deals?
47 Implementation Challenges Transition vs. New Deals vs. Monitoring
48 Implementation Challenges Transition vs. New Deals vs. MonitoringAN AUDITABLE PROCESS IS REQUIREDSarbanes Oxley – who will sign off on subjective decision?Consistent practice across company’s lease portfolioSubjective nature of decisions needs objective supportTerm – Renewal and Termination OptionsContingent RentsIncremental borrowing rateInitial direct costsNon-Lease Components / Observable CostsProcess / calculations / decisions revisited as circumstances change.Outside assistance / resources
49 Implementation Challenges Transition PlanningIts sooner than most realizeLead time to gather necessary information and documentsLead time to institute corporate process / standardizationDual Standards between now and Effective DateMultiple stakeholdersLegal, risk and compliance issuesERP Financial reporting systems
50 Implementation Challenges Transition Planning“Date of Initial Application” (DIA)Effective Date is “transition” date, but need to report based on new standard sooner, based upon comparative financial statement requirements of lesseeDetermining Your DIAIf Effective Date is 1/1/15 companies providing comparative financial statements:5 years = DIA of 20114 years = DIA of 20123 years = DIA of 2013Which leases to includeAll leases in effect on the first day of the lessee’s DIAAll leases executed between DIA and Effective Date
51 Implementation Challenges Transition PlanningDual StandardsBetween today and Effective Date, report based on FAS13Between Date of Initial Application & Effective Date,Report based on FAS 13Track based on New StandardsSystems and reporting must therefore track both standardsAsset & LiabilityAt DIA / Effective Date the Asset & Liability equal the PV of then-remaining lease paymentsAt DIA / Effective Date the Asset & Liability are calculated using the tenant’s then-current “Incremental Borrowing Rate”Yes, this means separate calculations each year between DIA and Effective Date!
52 Implementation Challenges Transition PlanningTeam MembersDirect Involvement:Corporate Real Estate LeadersBusiness Unit Real Estate TeamCorporate Finance (CFO, Treasury, Controller)Business Unit Finance3rd Party Expert Advisors & AuditLegalGovernance, Risk & ComplianceIndirect Involvement:Brokerage TeamsProject Managers (TI Costs)Landlord / Property Managers
53 Questions?Contact InformationMarc A. MaionaCyberLease, LLC18818 Teller Avenue Suite 250 Irvine, CA 92612Phone –Web –
54 What La Quinta is doing now Assessing scope of impactReviewing Timing of implementationUpdating inventory of leasesCompletenessSome provisions much more relevantVariable lease paymentsOptions and related penaltiesInterest rateInitial direct costsResidual value guaranteesTransfer of risk & reward (lessor)
55 What La Quinta will need to do soon Talk to OperationsAssess renewal option probabilitiesObtain input for estimating variable lease paymentsEnsure Accounting is “top of mind” for new leases, amendments, etc.Consider impact on owners, lendersEBITDAR?Consider periods needed for retrospective application