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Ten Things You Need to Know about the New Lease Accounting Standard August 23, 2010

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting.
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The “Exposure Draft on Leases” issued by FASB and IASB on August 17, 2010 is 66 pages of sometimes dense reading. I thought people might like a succinct  summary of what’s in it and what are its implications. At the risk of over-simplifying something that is pretty complex, here it is in ten little bites, starting with the main driver of the change … namely, the desire to make lease obligations more visible to investors by putting virtually all ….

Leases on Balance Sheets. (#1)   The present value of virtually all lease obligations will go on balance sheets in two places: as a “right-to-use” asset on the “left side” of the balance sheet and as an offsetting “lease liability” on the “right side”. This will not, though, be a simple calculator exercise; judgement will be required because the amount to be capitalized will be based on ….

Likely” Obligations, not “Minimum” Obligations. (#2)  The amount that goes onto the balance sheet is based on the “likely” lease obligation, taking into account factors such as the likelihood of exercising options to renew and the likely payments to be made as contingent rents. The need to make assumptions about options, contingent rents, foreign exchange rates, future market rental rates and the like, is going to lead to a lot of ….

Auditor Scrutiny. (#3)   Auditors will feel compelled to closely watch the assumptions used in calculating the amounts that go onto balance sheets. Where there are assumptions in accounting, there is room for manipulation. Most companies will want to make assumptions that minimize the amounts that go on balance sheets, and auditors will be watching for things like unsubstantiated claims that options to renew are unlikely to be exercised. They’ll also be scrutinizing the accuracy of P&L accounting for leases as that accounting becomes more complex as a result of the change to ….

Amortization and Interest Expenses Instead of Rent Expense on P&L. (#4)  Instead of a rent expense, companies will experience an amortization expense related to the right-to-use asset and also an interest expense related to the lease liability. The latter will be higher in the earlier years of the lease than in the later years, and therefore, so too, the total expense associated with a lease will be higher in the earlier years than in the later years.  Moreover and importantly, this total expense will be higher in the early years than what it would have been under existing accounting … and this will, when the new standard is first used, lead to ….

Busted Budgets. (#5)   Transition rules require that existing leases on the day that the new standard is applied will be accounted for as if they were new leases.  Therefore, in the early years of the application of the new accounting, virutally all leases will have a higher P&L expense associated with them than they would have had under existing accounting.  Most companies will experience an increase in lease expense of from 5% to 10% just due to the accounting.  This ratcheting up of lease expenses is going to reverberate throughout companies and have numerous ….

Downstream Effects. (#6)  The new accounting for leases will have many consequences, affecting everything from corporate and business unit budgets (and people’s bonuses!) … to real estate charge-back methodologies … to financial statement performance metrics … to compliance with bond and debt covenants … to cost-plus contract pricing.  In addition, the new lease accounting has important ….

Strategic Implications. (#7)  Three areas of strategy will be greatly affected. First, own-vs-lease decisions take on a new complexion as leases, particularly long leases, become undesirable. Second, lease duration becomes a more important decision putting the financial statement benefits of “going short” at odds with the desire to control space and lock-in current rental rates that can be had by “going long”. Third, longer-term consolidation planning takes on new value if it can substantiate assumptions that exercising of options to renew are unlikely. It is going to be crucial for companies to address these strategic implications, but it may be difficult for them because so many resources are going to be tied up dealing with ….

Compliance Complexity. (#8)  Most companies do not now have the processes, systems, personnel, and databases to comply with the new standard. A huge amount of work will be involved in establishing all of this infrastructure, and doing so will be challenging and complex because the infrastructure will need to transcend intra-company boundaries. This is why there is still uncertainty about when will be the standard’s ….

Effective Date. (#9)   The IASB and FASB plan on issuing the final standard by June 2011, but compliance will probably not be required immediately. It will be difficult for companies to put in place the infrastructure to comply and comments to that effect are likely to be made to the accounting boards during the Exposure Draft comment period which goes until December 15, 2010. Most observers think the boards will set the Effective Date for sometime in 2012 or 2013. That does not mean, though, that companies have the luxury of waiting before they address the new standard. There is much for them to do to get ready to comply. More importantly, though … from a strategic-point-of-view … the standard is already “in play” because there will be ….

No Grandfathering. (#10)  On the date that a company begins using the new standard, all existing leases will go onto the balance sheet as if they were brand new leases on that date. That means that leases being signed “today” will be subjected to the new accounting and that lease decisions being made “today” need to be viewed through the lens of the new accounting … which leads to my ….

Closing thought.  If you’ve not yet formulated your company’s response to the new lease accounting … by reviewing your real estate strategy and modifying it, as necessary … by revamping your decision-making framework and tools to incorporate the new accounting … and by laying out how you’ll go about planning and implementing the infrastructure needed to comply … then, you’re already behind.

A good way to learn more about the new accounting is to read my other blog posts on the new lease accounting where I’ve dealt with the strategic and practical implications of the new standard. You can easily follow my future posts by subscribing to the blog via email (which you can do on the right side bar).  You can also check out the webinar series on “The New Lease Accounting Standard and You” that I held for TRIRIGA and which is still available on-demand, or alternatively, read my companion white paper published by TRIRIGA.

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Comments»

1. Michael VanderGoot - August 23, 2010

Bob,

In the Exposure Draft para (Section) 89 it states “An entity shall adjust the opening balance of each affected component of equity for the earliest prior period presented and the other comparative amounts disclosed for each prior period presented as if the new accounting policy had been applied from the beginning of the earliest period presented.”

Doesn’t this mean we should be computing today because 2011 will need to be adjusted if the implemented in 2012 and there are comparitive statements?

2. Bob Cook - August 23, 2010

Michael,

Section 90 says that “at the date of initial application … [the liability should be] measured at the present value of the remaining lease payments” with Section 91 requiring that the present value be adjusted by “any recognized prepaied or accrued lease payments.” So, no, I don’t think calcuations need to begin today.

As for Section 89, it is very poorly written and has me (and, I imagine, others) flumoxed. Looks like it was at the last moment, squeezed in between Sections 88 and 90 because it stops the logical flow. Section 88 is clearly associated with and actually makes reference to Sections 90 to 96, but it has no reference to Section 89.

I’m hoping a clarification will be forthcoming on Section 89. In the meantime, if any readers have an interpretation, please leave a comment.

3. Three facts that compel you to tackle the new lease accounting NOW « Corporate Real Estate Strategy - October 17, 2010

[…] period that ends in two months.  And double-shame, if they haven’t briefed you on the details of the accounting and its transition rules, particularly if they haven’t explained to you the meaning of:  “no grandfathering” and […]

4. Lease Accounting Change Still Coming; Waiting for the Fat Lady to Sing « Corporate Real Estate Strategy - May 15, 2011

[…] 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 […]


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