This past May, the US and International Accounting Boards (the FASB and IASB) issued the Revised Exposure Drafts (RED) on proposed changes to the accounting for leases in an effort to seek greater transparency in operating cash flows. These changes are a drastic difference from those made in the original proposal from 2010, and it is believed that the majority of these changes will likely become the new standards.
What does this mean in layman’s terms? The new standards proposed in RED will significantly change how lessees and lessors account for and report leases in their financial statements. Here are a few of the notable changes:
- The pattern and presentation of lease expenses for many leases will be altered due to a dual-model approach for lessee accounting.
- The lessor accounting model will undergo significant changes.
- There will be new lease classification tests, applicable to most lessees and lessors.
- Lease terms will be estimated in a new way.
- Most variable lease payments will see new accounting rules.
The final standards are expected to be issued in early 2014, but are not due to take effect until January 2017 with a two-year look-back. In other words, there is time to prepare – but how?
Navigating the Nuances
According to the RED, leases will now be considered “right-of-use” and both lessees and lessors will be required to report leases exceeding 12 months on their balance sheets. This change will apply, with no possibility of grandfathering, to all entities that follow the FASB and IASB standards. Essentially, all non-contingent rent will be calculated as present value beginning at the lease commencement date. This present value will be the amount reported as the right-of-use asset and liability.
Additionally, new classification tests will be applied to most lessees and lessors who will have to classify a property as either Type A or Type B. Type A leases are equipment and Type B leases are real property. If the underlying asset is a property (defined as land, building or both) the lease would be classified as Type B unless: 1) the term is for a major part of the underlying asset’s remaining economic life, or 2) the present value of the lease payments is substantially all of the fair value of the underlying asset. Type B leases will generally be straight-lined, meaning the amortization of the asset would be calculated as the difference between the total straight-line lease expense and the interest expenses related to the lease liability for the period.
Lease amounts will also be calculated differently according the proposed new standards. Rent would initially measure the right-of-use asset as the present value of the rent it expects to pay during a lease term. Rent would be considered a combination of:
- The non-contingent rent
- Any indirect costs incurred by the lessee
- Any termination penalties or residual guarantees to be paid
- Any option payments the lessee has the incentive to exercise
- Any portion of the rent considered embedded operating costs
- Any lease incentives received from the lessor
Furthermore, a lessee will be required to re-measure what is committed rent if the lessee has any change in the assessment of what their lease payments and/or discount rate will be going forward. These changes could occur due to a change in an index or rate, a significant incentive to exercise a lease option, or a change in estimated payments made under a residual value option. The RED also discusses situations in which an entity should reassess the discount rate which include: 1) if there is a change in the lease term; 2) if
the lessee has an incentive to exercise an option to purchase the asset; 3) if there is a change to the referenced rate and payments are made based on that rate.
Another significant change resulting from the proposed standards will be the appearance of financial statements. For example, the size of the Balance Sheet will increase, showing right-of-use assets separately from other assets, listing Type A and Type B leases separately, and lease liabilities will be shown apart from other liabilities. The Income Statement will also noticeably appear changed. Lessees and Lessors will be required to report and account Type A and Type B leases in different manners. Changes will also impact subleases, sale-leaseback transactions and build-to-suit leases.
Corporate Occupiers Be Aware
While the new standards proposed by the RED will impact the industry across the board, it will especially be felt by corporate occupiers. Corporate occupiers will need to review and update lease databases and technology systems as they face significant implications including:
- Balance sheets will become more detailed and lengthy.
- Some expenses will be accelerated and thereby increased in early years.
- Compliance with existing financial covenants will be impacted.
- Expenses charged to business units will change significantly.
- Corporations may want to reevaluate lease vs. own models.
- Greater attention will be paid to lessor financing – especially in single-tenant buildings.
- Leases of 12-18 years will become much less attractive as the right-to-use asset value may exceed the underlying cost of the property.
Education and Preparation
As with any significant change, education and information are the keys to navigating unchartered waters successfully. First and foremost, read up on the information available in industry journals and online at fasb.org. The full report can be viewed online as well. Corporate occupiers of space and tenants who utilize long-term single-tenant leases will especially need to prepare for the changes as they are expected to be greatly impacted.
Secondly, review and possibly upgrade systems and technology to ensure that data is able to be captured as needed. Internal operating teams and systems should also be aligned for increasing work load and greater integration. Additionally, the corporate strategy must be updated regarding financial decisions, operating requirements and real estate decision making. The keys to success will include maintaining accurate data, considering alternate lease structures and possibly even decisions to purchase facilities in place of leasing.
January 2017 may seem like the distant future, but the new standards coming down the line will require significant changes to strategy, policy and procedure. Preparation and education are paramount to successfully and seamlessly implementing the coming changes. The time to take action is now.