Corporate Real Estate Strategy

Lease Accounting Rolling Forward after Two-Years of Spinning Wheels September 12, 2013

If you did a Rip Van Winkel and fell asleep a couple years ago listening to the whistle of the lease-accounting-change train as it rolled by … and you just awoke … you’ll be surprised to learn that lease accounting hasn’t yet changed.  You might find that hard to believe; I know I do.  The SEC called for an overhaul of lease accounting back in 2005, and while FASB was slow to react, by 2010 it seemed to be steaming fast towards a new standard.  Here we are now, though, in 2013, and FASB is still soliciting comments on lease accounting.  When all is said and done, it will have taken more than a decade for the inadequacies of current lease accounting to be corrected.

The proposed new standard is, though, still on-track; it never really derailed. Its wheels did spin a lot, though, climbing a mountain of protest over the implications for rent expense accounting and over the administrative burden the accounting creates.  The newest proposal from FASB provides relief on the former, but no relief on the latter.

Status of Proposal

On May 16^th, FASB and IASB issued a revised Exposure Draft on Leases.  This was a follow-up to public comment and discussions resulting from the Exposure Draft on Leases issued in August of 2010.  That Exposure Draft, by the way, resulted from public comment on FASB’s Discussion Paper on Leases issued back in March of 2009, which of course, was a response to SEC’s request from 2005.

Comments on the revised Exposure Draft are due September 13^th, but it’s hard to imagine any new issues will surface, given all the discussion that has taken place over the years.  Nevertheless, as of this writing, there are about 100 comment letters listed on FASB’s website.

Given the speed, or lack thereof, of the train so far, it’s foolhardy to try to estimate when a standard will arrive, but if a good head of steam gets going, it could be in first half of 2014. Then, while it will be another two or three years before financial statements reflect the new accounting, the required retrospective application to comparative years means that companies will need to establish new processes immediately upon adoption of a new standard.  So, better not take another nap.

 All leases still likely to go on balance sheet

The proposal still has all real estate leases going on balance sheet.  There will be a “right-of-use asset” on the “left side” of the balance sheet and an off-setting lease liability on the “right side”.  While at first blush, it appears that this is a “wash”, if you do the math you’ll see that company balance sheets will appear weaker as ratios such as liabilities-to-assets deteriorate.  For this reason, most companies would have preferred leases not be on balance sheet.  There has, however, been little opposition to the fundamental concept of leases-on-balance-sheets because the logic is too compelling.  For many companies, their single largest class of obligation is leases; without these leases on balance sheet, balance sheets are very misleading.

Difference from current accounting:  Under present accounting, only so-called “capital leases” go on balance sheet; all other leases, called “operating leases”, do not. Most companies have few capital leases.  Only leases that cross the line of one of the following tests are classified as capital leases: (1) the lease conveys ownership to lessee at end of lease or lessee has option to buy property at bargain price at end of lease, (2) term of lease is 75% or more of the life of the asset, or (3) present value of rents is 90% or more of the asset value.  Typically, only very long real estate leases cross these thresholds, and the existence of “bright line” rules have allowed companies to financially engineer borderline cases so those leases stay on the operating-lease side of the line.

Short-term leases:  While a company will be able to elect to not put short-term leases on balance sheet, a short-term lease is defined as one where the term, including options to renew, is 12 months or less.  The option-to-renew qualification means that not many leases would fit this category.

Most real estate leases will be expensed using a straight-line method

The big change FASB has made to its initial proposal for lease accounting is to leave P&L expense accounting for most real estate leases unchanged.  Most real estate leases will be classified as “Type B” leases. (See below for Type A vs Type B classification.)  Expensing for Type B leases will be straight-lined similar to today’s accounting rules for operating leases where, essentially, the rent to be paid over the term is divided by the number of months in the term with the result being the amount of rent to be expensed each month.  This method results in a rent expense that is constant throughout the term of the lease, even if the cash payments themselves are not constant.

Corporate real estate folks can breathe a sigh of relief.  The previous proposal eliminated straight-line rent expense, substituting two types of expenses: (1) a depreciation expense associated with the “right of use” asset and (2) an interest expense associated with the lease liability.   This interest-plus-depreciation expense would have resulted in expenses being higher in the early years of a lease than they would be under straight-line expensing; albeit, they would be lower in the later years.  (This interest-plus-depreciation expense method is, by the way, how capital leases are expensed today.)  This change would have played havoc with corporate real estate budgets, and required corporate real estate folks to have a sophisticated understanding of the intricacies of accounting to explain their budgets to stakeholders.

FASB felt, though, a lot of angst in allowing Type B leases to use straight-line rent expensing.  It’s not a technically pure accounting solution.  FASB has had to introduce new accounting mechanics so the straight-line rent expense can dovetail with the periodic reduction of asset and liability values as the lease term grows shorter.   Working through the issues related to this straight-line expense accounting was one of the major reasons that it has taken so long to finalize a new standard.

Type A vs Type B leases

FASB really wanted to have just one type of lease and one type of lease accounting.  Public comment, though, convinced it to establish two types of leases.  In general, Type A leases would be for equipment and Type B leases would be for real estate. There can be exceptions to each, but that’s the general construct.  Both types would go on balance sheet, but they differ in their P&L accounting.  Type B leases, as discussed above, will have a straight-line expense pattern.  Type A leases will use the front-loaded, interest-plus-depreciation expense method.  The logic is that equipment leases tend to be financing vehicles, in substance, and the interest-plus-depreciation expense method is what would naturally be used if the lease had been legally written as a loan instead of as a lease.

While FASB, who is trying to make a clean break from current accounting, takes great pains to not label Type A leases as “capital leases” (after all, that terminology will go away once new accounting is in place), conceptually that’s pretty much what they are.  There are two key similarities.  First, Type A leases will use the interest-plus-depreciation expense method just as capital leases do today.  And second, the tests that classify a real estate lease as one of those exceptions that need to be treated as a Type A lease are very similar to those that define a lease as a capital lease today.  The main difference is there are no bright lines, in keeping with FASB’s desire to move from rules-based standards (which encourage “style over substance”, sometimes unseemly, financial engineering) to principle-based standards.  In the case of Type A leases, the tests are whether (1) the lessee has a significant economic incentive to exercise an option to purchase the underlying asset, (2) the lease term is for the major part of the remaining economic life of the underlying asset, or (3) the present value of the lease payments accounts for substantially all of the fair value of the underlying asset at the commencement date.  Pretty much the same three tests as for a capital lease; just no bright lines.

In theory, the lack of bright lines will eliminate “style over substance” financial engineering.  Classification of Type A or Type B will be based on the substance of the transaction, not whether certain numerical thresholds have been crossed.  In the absence of bright lines, though, classifying leases will require judgment.  Some people think that, in practice, the industry will use the numeric thresholds in the current capital lease tests, ie 90% and 75%, as benchmarks to inform judgment, even though the numerical values will no longer serve as bright lines.

Administrative Burden

As for the administrative burden of the proposed accounting, it is real, and the revision to the Exposure Draft doesn’t provide any relief.  First, now that leases will appear prominently on the balance sheet, lease data and its reporting will have to meet a much higher standard of timeliness and accuracy than it does in most companies today.  Second, the Type A vs Type B tests will have to be conducted and without bright lines, these tests may be much more difficult to perform than are today’s capital lease tests.  Third, there will be new tests to make sure the right-of-use assets have not been impaired.  Fourth, lease accounting departments will have to track the asset and liability values for each and every lease.  And finally, the new standard calls for much more detailed disclosure of lease information in the notes to the financial statements than has ever existed previously. There likely will be a need for a statistical profile of a company’s lease portfolio so data will have to be recorded so that it can be adequately parsed.

So … the train’s still coming … bringing lots of change, lots of burden.  No time for napping.

Postscript:  Readers who have followed this blog may have noticed that I, myself, took a nap over the last couple years.  There wasn’t much need to post updates on the new lease accounting while the train’s wheels were just spinning.  Now that a new standard may be imminent, I’m back. If you’d like to see future blog posts, make sure to subscribe to receive notices when a new post appears.  You can do so on the sidebar.

As for new readers, check out my older posts on the lease accounting.  With the exception of references on how expense accounting for real estate leases would change to an interest-and-depreciation method (which now is not going to happen), all the other comment and analysis, particularly that related to the implications of the new accounting to corporate real estate executives, is still correct and relevant.  You can find those posts assembled here.

FASB will re-expose lease accounting draft, but looks to still issue by year end? July 22, 2011

Will lease accounting be re-exposed? Should the tail wag the dog? July 18, 2011

UPDATE:  ON JULY 21, FASB AND IASB DECIDED TO RE-EXPOSE THE LEASE ACCOUNTING DRAFT.  SEE MY NEXT POST FOR DETAILS AND ANALYSIS.

The second quarter of 2011 has come and gone … and FASB and IASB are still re-deliberating their proposal for a new standard for accounting for leases.  They had targeted the end of June for issuing the new standard but announced in May that they would take more time to make sure they got it right.  They say they now plan to issue by the end of this calendar year.

Some people are questioning whether the Boards can issue by year end.   People wonder if there will be a need to re-expose the standard, something  the Boards are doing for the new Revenue Recognition standard which has been on a similar parallel course.   If the re-deliberations for the lease accounting standard take the standard too far afield from that proposed in the Exposure Draft of August 2010 (the “ED”), the Boards will probably feel compelled to re-expose by releasing a new draft and giving the public time to comment on this new draft before finalizing.   In that case, the standard probably won’t be issued until sometime in 2012.  If, however, the re-deliberations don’t result in a standard too different from the ED, then no re-exposure would be necessary, and issuance by the end of 2011 should be possible.

So where are deliberations and how far from the original ED have tentative decisions moved the proposal as it now sits?  Will re-exposure be necessary?   Can this get done by the end of this year?

How has accounting proposal changed?

Earlier this month, FASB released a presentation that gives an update of how the ED proposal has changed through deliberations.  The take-away:  not very much.   They have made no change to the basic concept of putting leases on the balance sheet as right-of-use assets and lease liabilities.  More importantly, the Boards have made no or little change to the five elements of the proposal that were arguably the most controversial for lessees.  Specifically:

Definition of lease.  Many contracts that are not conventionally thought to be leases, may be brought under the umbrella of lease accounting.  The result:  some of the future payment obligations for these contracts will have to go on-balance sheet.  While the Boards have provided some clarification to the definition, they are largely sticking with the standard outlined in the ED.  A lease exists if the client controls the use of a specified asset,  with “control” being interpreted very broadly to include situations where a client receives all but an insignificant part of the benefit of an asset.

Pattern of expense recognition.  The new accounting results in the P&L expenses related to a lease being higher in the early years than in the later years.  For long leases, this pattern is very pronounced, and many comment letters received by the Boards criticized the pattern as not portraying the economics of the lease well.  The Boards investigated the possibility of defining two types of leases … finance leases and other-than-finance leases  … with the latter being accounted for using the “straight-line expensing” presently used for operating leases.  When the boards began this investigations, many observers jumped to the conclusion that the Boards had “reversed course”.  In fact, after considering the possibility of two types of leases, the Boards decided it wasn’t a workable solution … leading observers to claim, again, that the board had “reversed course”.  As of now, the Boards are contemplating no change to the pattern of expense recognition outlined in the ED.  Note: 180 degrees + 180 degrees = 360 degrees.

Capitalization of optional renewal periods.   The ED called for lease liabilities during optional renewal periods to be capitalized if it was more likely than not that the lease would be renewed.  This evoked an outcry from the public.  People questioned both the accounting validity of capitalizing renewal periods that were not yet contractually obligated and the cost/benefit of collecting this data given the complex processes that would have to be run to determine whether an optional renewal periods needed to be capitalized.  The Boards responded by abandoning the “more likely than not” test and replacing it with an “economic incentive” test.  Now, an optional renewal period will only be capitalized if there is a significant economic incentive to renew.  Initially, many interpreted this as applying only to situations where the economic incentive was embedded within the lease, for example, in the form of a renewal rate at a significant discount to market.  The Boards have clarified, though, that the test needs to go beyond contractual language and needs to look at the facts related to the specific asset and the lessee’s situation.  Presumably, for example, one would look at how much had been invested in the asset and how important the asset was to the lessee given its current business.  It looks to me like this test is not significantly different from “more likely than not”, and modifying the test is probably not going to force a re-exposure.

Re-assessments.   The ED required that a company reassess all the assumptions for its leases, e.g. those affecting whether an optional renewal period needs to be capitalized, each time it issues financial reports.  Many were worried that the need to revisit each and every assumption for each and every lease, each and every quarter, would be overly burdensome.  The Boards have now stated that these re-assessments would only be necessary if there was a significant change to a company’s business.   While many saw this as a major change,  I always felt that this is how companies would have implemented the standard anyway, and so I see this as more of a clarification of the ED’s intent.

Short-term leases.   The Boards received many comment letters opining that short-term leases should be excluded from the standard.   The Board has responded by saying that a company could opt out of capitalizing short term leases.  The catch, though, is that short-term leases will be deemed to be only those leases that have a maximum possible lease length of 12 months, taking into account options to renew.  This really limits the number of leases that would not have to be capitalized and is therefore just a minor change to the ED.  I doubt it would require re-exposure.

What clarifications have been made?

The boards have made a number of other statements that should be considered clarifications.  These regard elements of the standard addressing situations like sale/leasebacks, contracts with both service and lease components, purchase options, residual-value guarantees, variable lease payments, and foreign-exchange changes.  None of these clarifications seem important enough to re-expose the ED.

What is left to deliberate?

So, what is left to deliberate and might these remaining deliberations result in changes requiring re-exposure?   Possibly.

FASB outlines five areas still being re-deliberated:  Lessor Accounting, Presentation, Disclosures, Transition, Effective Date.  Only the first of these seems to have the potential to require re-exposure.  As for the others:

“Presentation” … the issue of how right-of-use assets, lease liabilities, and their related expenses and cash flow effects are presented on financial statements … is largely a technical matter that the Boards will determine, taking into account input it has already received from accounting firms.

“Disclosures” … which will define what details on a lease portfolio needs to be provided in a company’s footnotes … could be somewhat controversial because it will guide how much work companies have to do to assemble that information.  It is likely, though, that this section of the standard will not be too specific in detailing what information must be presented, leaving that decision to a company and its auditors.

“Transition” … which will outline how companies will begin to use the new standard and abandon the old standard … and the “Effective Date” … which sets the timetable for the transition … will be of interest to everyone, but does not seem to be something that would warrant re-exposure.

Lessor Accounting

The only remaining re-deliberation with the potential to force a re-exposure of the lease accounting standard might be lessor accounting, which has been a problem in terms of getting the standard out ever since the beginning of deliberations.  A couple years ago, the Boards were going to not address lessor accounting in the context of the new standard, which they intended to be just about lessee accounting.   A few months prior to issuing the ED, though, they decided that lessor accounting did need to be included.

Lessor accounting has turned out to be more difficult to develop than anticipated.  It was the primary reason the Boards missed their target of issuing the Exposure Draft by June of 2010 (and not issuing it until August 2010).  It could become the reason the Boards miss their target of issuing a standard by the end of this year.

The Boards have proposed two approaches to be applied in lessor accounting:  ”de-recognition” and “performance obligation”.  These represent major changes to lessor accounting and probably have a lot of issues yet to be ironed out.  If new elements are added to lessor accounting as a result of ironing out these issues, it may become necessary to re-expose the whole lease accounting standard.  The irony, though, is that lessor accounting is not that important to anyone.  Landlords, to the extent they are concerned about GAAP, are more concerned about accounting for cash flow, which would not be significantly affected by the new standard; they are not that concerned about accounting  for balance sheets or income statements.

That is why the Boards haven’t spent a lot of time discovering and resolving issues related to their proposal.  They seem to leave re-deliberations on lessor accounting to the tail-end of meetings; in fact, they’ve left it to the tail-end of the entire re-deliberation process.   This tail could, though, delay the whole issuance process if the Boards aren’t careful.

Will the Boards issue standard without lessor accounting?

The Boards have identified lease accounting as a high-priority project because today’s lessee accounting is severely broken.  It seems a shame if the Boards need to delay issuance because of lessor accounting which not many people care about, anyway.

I wonder if the Boards will find a way to issue the new standard this year by not including lessor accounting, except perhaps as it relates to a lessee’s subleasing.  The re-deliberations regarding lessee accounting are largely complete.   In fact, the Boards could possibly issue as early as the third quarter if they ignore lessor accounting.   They could then issue the lessor accounting later.

The Boards need to find a way to issue the standard without re-deliberations on lessor accounting getting in the way.  They can’t let lessor accounting delay lessee accounting.  They can’t let the “tail wag the dog”.

Workshops on New Lease Accounting May 23, 2011

Along with Grubb & Ellis colleagues, I will be holding workshops on the new lease accounting in Boston (June 7), Los Angeles (June 14) and Newport Beach (June 15).  These workshops are not just on what is the new lease accounting (something that accounting firms are better at interpreting), but rather they are on what are the implications of the accounting for corporate real estate departments.  

The agenda:

• Overview of proposed standard for lease accounting
• Update on FASB re-deliberations and the schedule for adoption of the new accounting standard
• Original Grubb & Ellis research on the balance sheet impact for local companies
• Implications for transaction structuring and real estate strategy
• Implications for real estate processes and IT systems
• Roadmap to compliance

The workshop is for corporate real estate executives.  If you would like to attend, contact me at robert.cook@grubb-ellis.com.

For more information, click below:

Grubb & Ellis Lease Accounting Workshop – Boston Area

Invitation to Grubb & Ellis Lease Accounting Workshop – LA and Newport Beach

Lease Accounting Change Still Coming; Waiting for the Fat Lady to Sing May 15, 2011

FASB and IASB are working feverishly to get their new lease accounting standard out.  They’ve admitted that they’ll miss their target date of June 2011 by a few months but claim to be as committed as ever to reform lease accounting.  Their goal: greater disclosure of lease liabilities.

Over the last few months, the accounting boards have met frequently to “re-deliberate” (which is their word) aspects of the new lease accounting they proposed in their Exposure Draft on Leases issued last August.   They’ve been trying to respond to objections raised in the more-than 700 comment letters they received during the comment period that ended December 15, 2010.  Bit by bit, the boards are addressing concerns raised and making tentative modification to their original proposal.  In general, though, the main tenet of the original proposal … that all leases go on balance sheets … remains intact.  In fact, the strategic and process implications of the new accounting are as big as ever.

So, where are we now?  Following is a summary of the accounting proposal as it now sits.   Be aware, though, that this is a digest.  It only covers main points, and it glosses over the many nuances of these points.

Also, remember: “the fat lady hasn’t sung yet”.  The “Re-Deliberation Opera” is still on and there could be more changes, reversals, and reversals of reversals in the offing.

For more information on the implications for real estate strategy and proceses, see my other posts on the new lease accounting here.  In particular check out an earlier post on “Ten Things You Should Know about the New Lease Accounting Standard” but make sure you read below to understand how the capitalization of optional renewal periods and P&L accounting are still being re-deliberated.

All leases will go on balance sheet.   The main thrust of the new accounting is to require lessees to capitalize their leases and put them on balance sheets … as both right-of-use-assets and lease liabilities.  A lease will be capitalized in an amount equal to the present value of its future lease obligations, discounted at the company’s incremental borrowing rate.  There has been little opposition to this idea of putting leases on balance sheets, and it will undoubtedly happen.

Don’t be confused about talk that the accounting boards are considering the possibility of allowing two types of leases: “finance leases” and “other-than-finance leases”.  First, the boards are second-guessing their idea of having two types of leases, and so the concept might not survive.  Second, though, if the concept does survive, know that the reason the boards are considering two types of leases is only to allow two different types of expense recognition for P&L accounting. (See below.) Both types of leases would still go on balance sheet.

More than just minimum rent obligation will go on balance sheet, but we’re not yet sure how much more.  Companies will have to capitalize more than just their minimum rent obligation.  They will also have to capitalize some types of contingent rent and some optional renewal periods.  It looks like contingent rent will have to be included as long as it is based on something other than business conditions. For example, rent escalations tied to CPI would have to be included, but rent that is determined as a percent of revenue, such as for a retailer, would not.  (The latter case, though, changes if the threshold of revenue at which that contingent rent kicks in is so low that the contingent rent is deemed to be “disguised base rent”.)

As for optional renewal periods … one of the most contentious aspects of the proposed accounting … the accounting boards have tentatively changed their original proposal and now propose that an optional renewal period would only be capitalized if there is a “significant economic benefit” to exercising the related option. The boards have not, however, provided any guidance on what would constitute “significance” … and it is unclear if they will … and so it is uncertain at this point how significant this “significance test” will be in reducing the number of optional renewal periods to be capitalized. (It seems to me that most options to renew carry a significant economic benefit in the form of avoidance of relocation costs.)

The original proposal would have required capitalizing the optional renewal period when it was “more likely than not” that the renewal would occur.  It was strongly criticized on three counts: capitalizing renewal periods for which companies are not obligated, requiring difficult-to-make forecasts of whether a lease will be renewed, and requiring complex processes to make those forecasts.  Presumably this ”more likely than not” wording has gone away, but conceptual gaps seem to exist, such as whether or not the likelihood of renewal is to be considered before capitalizing a renewal period associated with an option containing a significant economic benefit.

The boards still have work to do in defining when obligations related to optional renewal periods should be included.  They will almost definitely require some optional renewal periods to be capitalized; otherwise companies would be able to structure short leases with options to renew as a way to avoid capitalizing lease periods that will inevitably occur.

The pattern of expense recognition will be high in early years … for at least some leases … and maybe for all leases.  The straight-line pattern of recognizing lease expenses evenly over the course of the lease … as is done today with operating leases … may no longer exist.  The original accounting proposal was to entirely do away with today’s P&L accounting for leases (which, BTW, is the accounting most companies use for their internal budgeting).   The proposal was to replace rent expense with two new types of expenses: amortization of the right-of-use asset and interest on the lease liability.  The latter would be higher in the early years of a lease and lower in the later years, just as is the case in a self-amortizing loan. The resulting high-then-low expense recognition pattern was criticized in many of the comment letters, and so the boards are considering the possibility of defining two types of leases … “finance leases” and (the presently inelegantly named) “other-than-finance-leases”.  The new expense recognition pattern would apply only to the former; the latter would have a straight-line expense recognition pattern similar to today’s expense recognition pattern for leases.  (Whether it would be categorized as rent expense or as asset amortization and liability interest is unclear.)  Debate continues, though, particularly as it is becoming clear to the boards that defining two types of leases creates definitional problems, might require the types of “bright line” rules that are inconsistent with the boards’ goal of creating a principles-based standard, and would likely increase the complexity of compliance processes.

The new accounting will apply to some contracts you do not now think of as “leases”.  A big issue that has caught a lot of people by surprise is that the new accounting necessarily will apply to implicit leases, i.e. those contracts that may not be thought of as being leases but which convey to the buyer the right to control one of the vendor’s assets and specify exactly which asset is used.  An example is a photocopy contract which might be thought of as a service contract but which … because it conveys control over specified assets … would be deemed to contain a lease.

The issue applies to assets much larger than photocopiers, though.  Think buildings.  An example might be a logistics contractor who manages logistics for a customer out of a warehouse that is used solely for that customer.  Such a contract might be deemed to contain a lease, and the customer would have to put, on its balance sheet, a portion of the projected future payments to be made to the logistics contractor.  See my previous post on this topic.

Initial application of the new standard may be only a year away … long before the “Effective Date”.  The boards have not yet specified when the “Effective Date” of the new accounting standard will be.  When they do, there is likely to be much misunderstanding because the “Effective Date” is a misnomer.  Companies will actually have to begin applying the new standard retrospectively to leases a couple years prior to the effective date.

According to the Exposure Draft on Leases, the Effective Date will apply as follows.   A company will have to apply the new standard to its annual financial statement for any fiscal year that begins after the Effective Date.  This means, for example, if the the Effective Date was designated as December 31, 2014 (which would be three years after the anticipated issuance of the standard by the end of this calendar year)  any fiscal year starting after that date would have to use the new accounting in its annual statement.  Let’s say the company’s fiscal year began on February 1, 2015, the annual statement for the year ending January 31, 2016 would be the first time that the company would report using the new standard.

That sounds like a long time from now, but consider this: the standard will require that the company retrospectively apply the standard to any financial results for prior years that it presents for comparison purposes in its FY2016 annual report.  The typical company presents two years of prior results and so would have to recast its FY2015 and FY2014 statements using the new accounting.  The latter fiscal year begins on February 1, 2013 and so the company would first apply the new standard on that date, even though it won’t report using the new standard until three years later.

Continuing this hypothetical (but very possibly real time table), February 1, 2013 is only a little over a year after issuance of the standard, assuming issuance by the end of Calendar Year 2011.  This leaves little time to put in place the processes to collect the information and make the assumptions (such as for optional renewal periods) needed for this retrospective application. While companies will not absolutely have to have these processes in place before the initial application, if they don’t, they risk losing information that will later be required for this retrospective application forcing them to undertake the time-consuming and costly reconstruction of historical data and the determination, to the satisfaction of their auditors, of what assumptions they would have likely made in early time periods about things like optional renewal periods, contingent rents, etc.  Putting processes in place to capture this information prior to the date on which initial application takes place will be a wise choice.

There will be no grandfathering of existing leases.  Leases that are already in place today, as well as those signed between now and the Effective Date, will go on balance sheet on the Effective Date if they are still active.  Considering this, the standard … even though it is not yet set … is for all practical purposes already in effect.  Companies should already be taking the new accounting … at least those aspects that are not under debate … into account in setting strategy and making decisions.  This is something that few corporate real estate execs truly understand yet.

Standard will probably be issued before end of this calendar year. Once the boards issue the new standard, companies will have to shift into high gear to address the strategic and process implications.  Companies should already be mobilizing to do this.  I suspect many are not.  For their sake, let’s hope the  fat lady sings the finale of the “Re-Deliberation Opera” loud enough for them to hear.

Lease accounting update: “more likely than not” is no more February 17, 2011

FASB/IASB have dropped one of the most controversial parts of their proposed lease accounting.   The Exposure Draft, released in August 2010, had called for lessees with options-to-renew to capitalize lease obligations for renewal periods that were “more likely than not” to occur.   This part of the accounting was attacked on many grounds.  First, it was going to require lessees to undertake a lot of work in making the assumptions as to whether renewals were more likely than not to occur, and many thought the benefits to users of financial statements were not great enough to justify the expense of compliance.  Second, in many cases the assumptions would end up being arbitrary, bringing into question whether capitalizing renewal periods had any value.  Third and perhaps ultimately most important, it seemed to fly in the face of other accounting doctrine.  Until a lessee signs up for a renewal period, regardless as to whether an option-to-renew exists, the renewal period is not an obligation.  It just didn’t seem right to put it on the balance sheet.

I think FASB/IASB made the right choice in eliminating this part of their proposal and had recommended that writers of comment letters to FASB/IASB point out the flaws and problems associated with capitalizing renewal periods.  Many others made similar recommendations, and many of the 700-some comment letters received by FASB/IASB recommended that this aspect of the accounting be eliminated.

The people have been heard!

Before “the people” start celebrating, though, they should understand that there will still be a need to evaluate each and every lease, with an option to renew, to determine whether there is an economic incentive in that option such that renewal of the lease is “reasonably assured” … in which case the renewal period would have to be capitalized … just as is the case under present accounting for capital (or financing) leases. 

This test will be much less onerous, though.  FASB/IASB are going to work on the exact wording, but this “reasonably assured” test has a much higher bar than would have the “more likely than not test” … akin to the difference between 99% and 51%.  Few leases will go over the bar and most won’t even come near it so assumption-making will be much easier, and easier to justify to auditors, than it would have been with “more likely than not”. 

Still, though, lessees will have more to do than they do today.  Under today’s accounting, most companies only need to apply the “reasonably assured” test to a very small group of leases that, due usually to their long length, are classified as capital leases.  Many companies have no such capital leases.  Now, though, companies will have to apply the test to all leases.  The process burden will be much, much less than it would have been with “more likely than not” … but it’s going to be measurably more than it is at present.

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Do privately-owned companies need to use the new lease accounting? December 27, 2010

Would Scrooge & Marley have to use the new lease accounting?

This is a question I am often asked.  It’s a good one.  The accounting clearly applies to publicly-owned companies.  They are regulated by the SEC (in the U.S.) which requires the use of GAAP (i.e. generally accepted accounting principles) of which the new lease accounting will become part.  But, what about non-public companies?

Some private companies may choose to ignore the new lease accounting; in fact, some already ignore GAAP altogether.  A small family business … to the extent it keeps books at all … may choose to use any accounting rules it likes …. or at least as long as the family members agree.  For larger companies, though, particularly those with non-familial owners, accounting needs to be more sophisticated; many, perhaps most, will want to apply the new standard.

The reason: If the company needs to provide financial statements to anyone for any purpose, it probably needs to use GAAP in all its aspects, otherwise the party receiving the financial statements won’t be able to interpret the meaning of the financials.   To be more specific, if a company needs to show financials to a bank to borrow funds or to a customer to prove its ability to perform a contract or to partners to show how well the company is doing, then the company probably needs to apply the new lease accounting standard.

I stick in the word “probably” because there may be some companies that are thought to be so sound financially that they are able to be cavalier about how they prepare their financial statements. Also, some companies in some industries, notably real estate investment, feel that GAAP doesn’t really describe the financials of their business well and they use a modified GAAP.  In those situations, the new lease accounting will probably be ignored.   For any company that uses GAAP, though, they’re going to have to use the new accounting.