JLL Perspectives Lease Accounting 2010

8/8/2019 JLL Perspectives Lease Accounting 2010

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A long-anticipated draft of proposed lease accounting changes

that will put all leases on balance sheet was released on

August 16, 2010 by the U.S. Financial Accounting Standards

Board (FASB) and its counterpart, the International Accounting

Standards Board (IASB). By now, most corporate real estate

executives are aware of the new paradigm for lease accounting

and its impact on the balance sheet. The reality of the proposal

is now shifting the focus to potential changes in leasing strategy

and practices as well as meeting requirements for future

administration of leases.

The Exposure Draft is the latest step in a long-running process to

require capitalization of all real estate and equipment leases on

balance sheets by recognizing the rights and obligations of lessees.

Although a 120-day period of public comment follows the release of

the Exposure Draft, the primary elements of the new rule are unlikely

to change. A nal standard is expected to be issued mid-2011 withan effective date yet to be determined but likely to be no sooner than

January 1, 2013.

Timeline of events

Perspectives on

lease accounting

What to make of new lease accounting rules

The pressure to revamp the three-decade-old leasing standard is

driven by the perceived lack of transparency around off-balance

sheet obligations and the complexity of current lease accounting.

Today, enterprises choose between two methods for classifying

leasesas operating or capital leases. Under the new approach,

organizations will recognize a liability for obligations to pay rent and

a corresponding asset representing the right to use the underlyingleased property.

Placing the full lease obligation on the balance sheet and the

resulting negative drag on corporate earnings will have a dramatic

impact on companies perceived nancial performance. Changes

in the nancial reporting process will be daunting and cumbersom

as companies must capture new data points and capitalize

obligations based on internal evaluation of occupancy practices

and use of property.

September 2010

2010

Exposure draft

August 17, 2010

Target effective date of

new standards

2011 2012 2013

Comments due

December 15, 2010

Final standard issued

mid-2011


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How will companies respond?

A major open question is how dramatically companies will react

and how signicantly they will alter the use of leases and desiredlease terms. A knee-jerk response may be for companies to seek

shorter term leases or favor ownership if property use goes on the

balance sheet anyway. Certainly, the changes will push companies

to articulate and validate the reasons for leasing such as exibility in

occupancy and preservation of capital for core business activities.

Given the principles-based approach to the new leasing standard,

certain transactions such as sale-leasebacks and build-to-suit

arrangements could be easier to execute. Importantly, they may be

achieved with better economic terms for tenants and more suited to

their true business objectives. While the standard setters concernsabout nancial engineering of leases frame much of the new

approach, these transactions may better align with corporate goals.

The new standard will disproportionately affect certain business

sectors with a heavy reliance on real estate to generate revenue.

Obvious industry candidates are retail but also commercial banking

with substantial customer service operations. Retailers operating

on notoriously thin margins will witness a substantial erosion of

net margin. For retailers, the reported increase in occupancy

expense will be exacerbated by a potential tendency to capitalize

renewal periods and recognize higher rents under percentage sale

arrangements.

Although the transition date is not yet specied, the sweeping

changes in nancial reporting for leases will prompt companies to

begin planning for system modications immediately. The immediate

demands will be to:

Assess the suitability of existing lease administration and

reporting systems to accommodate the new accounting

requirements

Plan for enhancement of lease abstracts and processes for

additional data capture for existing leases

Create standards for assessment of obligations for lease

term, net lease expenses and contingent rent that will survive

audit review

Sale-leasebacks

The Exposure Draft offers immediate gain recognition for any

properties deemed to have been sold under a sale-leaseback

arrangement. However, the proposal incorporates many of the

Whats changing?

The distinction between operating leases and capitalleases will be eliminated

All leases, including existing arrangements, will goon balance sheet and rent will no longer be anoperating expense

Capitalization of leases based upon the present value

of estimated net lease payments over the expectedlease term, discounted at the lessees incrementalborrowing rate

Capitalized value will include base rent, net of operating

expenses, for the longest term of lease that is more

likely than not to occur, with consideration of renewalperiods and termination rights, and the expected valueof contingent rent and other payment amounts over thesame period

Continuous reconsideration of estimates used in

capitalizing lease liabilities

All existing leases will be capitalized based on theremaining lease payments

Whats the impact?

Balance sheets will swell and selected companies will see

their debt loads increase by a multiple of 7 to 10 times

Total occupancy expense will be higher and front-loadedover the rst half of the lease, often 15-20 percent

higher than todays straight-line rent (see comparison ofrent expense on page 3)

Re-amortization of asset and nance expenses from

remeasurement, albeit at the original discount rate,will potentially result in a continuously front-loadedexpense prole

Organizations must contend with potential violation ofnancial covenants

Reported capital spending will be higher

Sectors such as regulated nancial services and

government contractors will be negatively impacted

Financial reporting will become more complex andcumbersome with added burden of continuous re-evaluation of assumptions

Reported cash ow (EBITDA) will be greater

Occupancy expense allocations to business unitscould change


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current limitations on continuing involvement of the seller under U.S.

GAAP (which are more subjectively evaluated today under IFRS).

These limitations include features such as purchase options other

than at fair value, seller nancing and shared appreciation. Any

leaseback terms that are not at market, such as rent, will require an

adjustment to the recognized sale value and gain.

Subleases

Whenever a tenant subleases its space, an additional asset must be

recognized for the rent receivable and a liability for the sub-landlords

performance obligation. This will require the tenant / sublandlord tomake similar decisions around its subtenants occupancy as it made

on its own occupancy. In addition to the primary right of use asset

and liability, sublease amounts will need to be recognized but will be

presented on a net basis.

Build-to-suit leases

Development arrangements are not addressed in the Exposure

Draft since they relate to the pre-lease period and are not, therefore,

part of lease accounting. However, all leases will need to be

recognized when they are executed even though the lease has not

yet commenced.

Additional complexity in applying the standard will arise from situations

such as statutory leasing provisions, rent reviews, impact on regulated

industries, lease modications, impairment and deferred tax assets.

Corporate Real Estates Role

Because property leases represent roughly 70 percent of

all operating leases, corporate real estate (CRE) directors

play a key role in this process. In 2005, the Securities and

Exchange Commission estimated that U.S. public companies

had a capitalized equivalent of $1.3 trillion in operating leases,

translating to approximately $1 trillion in real estate obligations

that will need to be capitalized.

As the reality of the new standard approaches, many CRE

directors have been proactive in alerting nance executives at

their companies about the changes and their likely impact. In

recent months, more and more companies are starting to addres

the daunting challenge of preparing their existing lease portfolio

and reassessing the process for structuring effective leases goin

forward. This reassessment has four essential components:

Understand and quantify the impact - test how negotiated1.

lease terms drive the balance sheet and operating expense

Communicate with corporate treasury and accounting about2.

the changes, decisions and reporting needs for the future

Anticipate and plan for new nancial reporting identify3.

additional data acquisition and make changes to lease

administration systems

Re-assess negotiated lease terms and principles for lease v4.

own decision-making

Sweeping changes in lease accounting will give CRE executivesvaluable opportunity to support the fundamental business reason

for leasing and to clarify when nancial reporting objectives are

merely a subsidiary issue. Placing the focus on valued operatin

exibility and preservation of capital for core business investmen

will help organizations navigate through the undoubtedly

challenging time ahead with new lease accounting.

Years

Expense

$1,000,000

$1,100,000

$1,200,000

$1,300,000

$1,400,000

$1,500,000

$1,600,000

$1,700,000

$1,800,000

$1,900,000

1 2 3 4 5 6 7 8 9 10

FAS 13 Rent Right of Use Expense Cash Rent

Comparison of rent expense

For more information, please contact:

Mindy Berman

Managing Director, Capital Markets

+1 617 316 6539

[email protected]

Vivian Mumaw

Director, Global Lease Administration

+1 312 228 2878

[email protected]

www.us.joneslanglasalle.com

2010 Jones Lang LaSalle IP, Inc. All rights reserved. No part of this publication may be reproduced by any means, whether graphically, electronically, mechanically or otherwise howsoever,including without limitation photocopying and recording on magnetic tape, or included in any information store and/or retrieval system without prior written permission of Jones Lang LaSalle IP, In

All information contained herein is from sources deemed reliable; however, no representation or warranty is made to the accuracy thereof. Jones Lang LaSalle Brokerage, Inc., California license01856260. Jones Lang LaSalle Americas, Inc., California license # 01223413.


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2010 Jones Lang LaSalle IP, Inc. All rights reserved. No part of this publication may be reproduced by any means, whether graphically, electronically, mechanically or otherwisehowsoever, including without limitation photocopying and recording on magnetic tape, or included in any information store and/or retrieval system without prior written permission ofJones Lang LaSalle IP, Inc. All information contained herein is from sources deemed reliable; however, no representation or warranty is made to the accuracy thereof. Jones Lang

LaSalle Brokerage, Inc., California license # 01856260. Jones Lang LaSalle Americas, Inc., California license # 01223413.

JLL Perspectives Lease Accounting 2010

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