The two accounting boards (the FASB and the IAS ) have concluded their four city, international roundtable discussions after receiving 750 written comments on the Evaluation Draft (ED) of the proposed changes to Lease Accounting. For a four article background on the ED and the potential concerns and impacts on real estate owners and occupiers in North America please visit our blog at http://advance.beyond-the-building.com

In this article we will recap the major themes brought to the board’s attention concerning real estate leasing.

The boards reaffirmed the requirement for leases to be record as an asset and a liability for most leasing transactions and the boards still expect to issue a final standard in June 2011. However, the boards may reconsider the most controversial parts of the ED, including the following:

• the definition of a lease,
• the treatment of contingent rentals, and
• the inclusion of renewal options.

Lease Definition

The majority expressed concern that the definition of a lease in the ED is too broad and may include contracts that are really service contracts. Many also expressed concern about determining whether items such as common-area maintenance, insurance, and property taxes would represent “distinct” services that should be accounted for separately from the lease arrangement. This is an issue we first highlighted in a previous article.

The boards began tackling this at their January 2011 meeting but no outcome was achieved.

Variable Lease Payments and Contingent Rent

Many letters objected to the proposal’s inclusion and treatment of variable and contingent rent, with several stating that the ED approach could add significant earnings volatility and would add significant costs to implement. Several comments were concerns about the reliability of estimates for long-term leases.

Many opposed the use of a probability-weighted approach to estimate any contingent lease payments, citing the complexity of the model and the subjective requirements to determine probabilities. As an alternative, many suggested using a “best-estimate” to determine the lease payments.

It is not yet clear how the boards will deal with the divergent views expressed by respondents to this part of the ED.

Lease Term and Renewal Options

The ED states that the lease term to be placed on the balance sheet should be the “longest possible term that is more likely than not to occur.” The vast majority of letters disagreed with this approach noting as the most common objection that rental in a renewal period does not represent a liability until the lessee actually exercises, and thus commits to the renewal option(s). Most felt the provisions in the current accounting standard for lease term are suitable. Specifically, if a renewal option is reasonably assured to be exercised, then the renewal period would be included. Others feel a renewal option should only be included if it is completely certain to be exercised.

Based on the volume of criticism in this area, many believe the board will set a higher threshold to include the renewal terms, from ‘most likely’ to ‘reasonably assured’. It is unclear if the boards will still require a continuous reassessment of this as expressed in the ED – with the incumbent management costs- given a higher threshold.

Expense Recognition

Most comment letters and round table participants disagreed on how a lease should be stated on a lessee’s income statement, or a lessor’s income statement when the lessor is using the performance obligation approach according to the ED. They argue the ED would result in:

• higher expenses in earlier periods of the lease and
• greater divergence from the cash payments actually made.

Government contractors and non-profits also noted concerns of using an interest and amortization expense as compared to rent expense.

At the January 2011 board meeting some members seem divided on the way to tackle this issue so we may expect some changes to the methodology suggested in the ED.

Lessor Accounting Model

Several suggested there was no need to amend the current U.S. GAAP and IFRSs lessor accounting standards. They felt the performance obligation approach or the derecognition approach outlined in the ED are not an improvement over the current standard. Many felt that the lessor accounting proposals need further refinement and guidance to determine which approach to use.

There was no agreement on lessor accounting. Some wanted the current model left as is while giving further guidance for subleases and sale-leaseback transactions; others opined one model based on the derecognition approach (which simply doesn’t work in most real estate situations); while others wanted an approach consistent with another ED currently under consideration regarding revenue recognition.

Most comments from lessors in the real estate industry advised the board that real estate leases are fundamentally different from equipment leases. Some reasons for the difference were:

-          that real estate lessors are involved in the active management of the asset,

-          the asset is typically not depreciating nor depleted,

-          the rental rates are market driven rather than based on financing of the space being leased in addition to the underlying value, and

-          the lease only covers a small part of the useful life of the asset.

Fundamental to the basic comment was the opinion that the economics of the lease will become obscured in lessors’ financial statements taking the recognition on the income statement further from the real cash payments. This is caused by front-loading income even as payments may be increasing due to rent steps over the term.

At the January meeting the boards agreed to first review issues common to both lessors and lessees before reviewing the lessor’s accounting approach.

It must also be noted that the boards intend to release an ED on new standards for investment property before the end of the first quarter of 2011. Many in the real estate industry want to be assured that the currently separate EDs on Lease Accounting, Revenue Recognition and Investment Property are consistent with each other.

Retail Lessees

Retailers specifically are one of the most impacted industries by the proposed accounting standards and as a whole have their own concerns, in addition to the general issues previously noted.  As such the industry had significant representation at the round tables and provided a large percentage of the response letters. The additional concerns included the overall cost of implementation and compliance, the subjective nature of estimates for lease terms and contingent rent (including percent rent) and the treatment of lease incentives, a subject ignored in the ED.

Competitive Comparability

Many publically traded retailers questioned the ability to compare competitors even with identical contractual commitments, given the subjective nature of each company’s estimates of lease terms and contingent rent.

Forward Estimates

Many retailers expressed concern that a potential and unintended consequence of adopting the ED as drafted would be a need for long-term, store-level revenue forecasts (to determine lease renewals, contingent percent rents, etc.) These best guesstimates would be subject to error and unreliable.

There is disagreement by retailers that the lease should even be on the balance sheet. Some argued that a property lease is not like a financing arrangement as in an equipment or vehicle lease. For example they cited mall retailers who must lease the premises and do not enjoy the option of purchasing. Therefore, no buy-lease decision is made as in a financing model so the current operating lease accounting treatment would be appropriate.

Many also said the front- loaded expense of the lessee right-of-use model is magnified for long-term leases and the issue is replicated each time the tenant enters into a new lease.

Other Industry Concerns

Other industry sectors such as telcos, financial institutions, government entities, non-profits and healthcare all had additional concerns specific to their industries. We will deal with those in a separate, brief article.

Summary

The boards have committed to release the final standard by the end of Q2, 2011. Some have countered that given the significant changes proposed in the ED and the significant reaction and opposition to the original proposal the board release a second, revised ED with a time period for further comment.

It is unclear what the outcome of a second ED would be and the boards may reject the idea of issuing a second ED for fear of creating an endless loop of input. If the boards decide to go through a second round of commentary, then it would be reasonable to expect the implementation date of new lease accounting standards would be pushed out to 2013.

One of the most significant of these is the determination of the service contracts vs lease payments. Landlords and tenants should continue to make plans to address base stop leases, gross leases and modified gross leases. This will require research and resources to research and quantify the amounts to be categorized. And this need not wait until the final standards are released as the passage of time will only complicate the task.

We also continue to believe that a prudent approach to the lease is to migrate to a Triple Net or carefree lease form rather than base stop leases. This simplifies the information management and reduces internal costs. Another area unlikely to change, in our opinion, is the lack of grandfathering of existing leases. This will impact leases entered into today even if the implementation date is postponed to 2013. This is another reason to considering a different lease form as soon as possible.

Need Help?

We can help. Our associates can assist you in every step of implementation and ongoing compliance regarding your real estate from education and advice to historic lease cost research and verification to handling the complete implementation process (starting with pre-implementation activities) and landlord/tenant enquiries.

Call us today to learn more at 213-840-9879

© 2011 Peter D. Morris SCSM, SCMD, CLS

pmorris@beyond-the-building.com

www.beyond-the-building.com

http://advance.beyond-the-building.com