Download FASB Viewpoint - Cresa - The Tenant`s Advantage

Accounting
Lease Accounting Update
Just 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 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.

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”.

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:

o
Reduction to shareholder equity;
o
Debt-to-equity and current ratios reduced;
o
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.
o
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).
o
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.
o
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 US-GAAP 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;

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.

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.

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 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]