FASB IS CHANGING LEASE ACCOUNTING FOR EVERYONE

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1 VIEWPOINT FASB IS CHANGING LEASE ACCOUNTING FOR EVERYONE In recent months the US and international accounting boards (the FASB and IASB, respectively) have issued final new standards that have a significant impact on how leases will be reflected in financial statements going forward. The two boards have reached a general consensus on the long-anticipated changes to lease accounting rules under US-GAAP and IFRS. Companies following GAAP or IFRS will be required to adopt the standard for fiscal years beginning January 1, 2019, and financial statements issued in 2019 will include a look-back for two prior years, to 2018 and Companies will have the option to begin reporting under the new standards as early as 2018, if they desire. Private companies can delay the change in reporting until fiscal year These changes will significantly alter how leases impact a company s financial statements, but the impact of these changes will also affect many areas of corporate life outside of accounting, including corporate real estate, internal controls, information systems and operations. Some of the most critically important issues every CFO must understand include the following: 1. Despite serious efforts to achieve a converged standard between FASB and IASB, the new standards are not fully converged. The most significant difference between the FASB and IASB new rules is the IASB rules use one model for accounting for all leases, while the FASB standards utilize a dual model approach - these two models have very different financial statement impacts. 2. All leases, both existing and new, which have a maximum possible term greater than 12 months will be coming onto the balance sheet with a Right of Use Asset and a Lease Liability. 3. By virtue of the fact that the liability balances will almost always be greater than the asset balances, the impacts to balance sheet metrics are material, and include the following: Reduction to shareholder equity Debt-to-equity and current ratios reduced Reduction to regulatory capital, such as Tier 1 capital for banks 4. The income statement impacts from a lease under the new standards can and in many cases, will look very different than under existing standards. 5. For companies reporting under IFRS, all leases will have a front-loaded profile on the P&L, comprised of interest expense and amortization expense. Hence, as contrasted against existing operating lease treatment, profitability will be more adversely affected at the beginning of a lease term and improved at the end of it. EBTIDA will improve throughout the lease term by virtue of the elimination of straight line rent expense for operating leases under current rules.

2 6. For US-GAAP reporting entities, most real estate leases will have what appears to be straight line rent expense reported on the P&L, but which is actually comprised of interest and amortization expense (with the corresponding amounts required to be disclosed in the notes to the financials). 7. Because of FASB s dual model approach, it is also possible for US-GAAP preparers to end up with real estate leases having the same front-loaded, but EBITDA-friendly profile on the P&L as under IFRS. The importance of this is CFOs will want to ensure their leases are negotiated with everyone s eyes open to the different P&L impacts possible under FASB s new rules. 8. In many instances, renewal options, and other options, will significantly alter the P&L impact from a given lease, and those impacts could include either a worsening or an improvement of net income or EBITDA, or both. This will be triggered if significant economic incentives exist. These incentives are a new, subjective judgment test which must be applied consistently by a corporation. Big Picture Details For all leases with a maximum possible term longer than 12 months, tenants will include such leases on their balance sheet on the principle that a right-of-use asset and a financial obligation have been created. This will apply to all entities that follow the FASB or the IASB standards regardless if they are public, private, or not-for-profit. Importantly, there is no grandfathering of existing leases. In short, all non-contingent rent (the rent that is committed and realistically expected to be paid) will be calculated as a present value as of the lease commencement date. That present value will be the amount of the lease liability and, subject to certain adjustments, the Right of Use Asset. The asset will reflect the tenant s right of use for the leased property and the liability will reflect their obligation to make lease payments. The right-of-use (ROU) asset and lease liability would initially be recognized in essentially the same way the capital lease is recognized under the current US GAAP. However, under FASB s new rules, the subsequent measurement of the asset for most real estate leases would differ from the way capital leases under current US GAAP are measured during the lease term. LEASES WITH A MAXIMUM POSSIBLE TERM LONGER THAN 12 MONTHS WILL BE INCLUDED ON TENANTS BALANCE SHEETS ON THE PRINCIPLE THAT A RIGHT- OF-USE ASSET AND A FINANCIAL OBLIGATION HAS BEEN CREATED.

3 The New Classifications for Leases Despite the FASB s and IASB s efforts to reach a consistent set of new lease accounting standards under both US-GAAP and IFRS, in the course of finalizing these new standards the Boards diverged on whether to have one set of rules for all leases, or to have different rules for different kinds of leases. Ultimately the IASB opted for a single model approach, in which all leases are referred to as Type A leases. Conversely, FASB s new rules utilize a dual model approach which includes Type A leases but also Type B leases. Among the differences in the new rules from the FASB and the IASB, this is the greatest difference in their respective standards. Type A (Finance) Leases For Type A leases, the balance sheet and income statement impacts are generally consistent with the way in which a capital lease under existing standards impacts financial statements. In other words, the lease liability is drawn down during the term of the lease based upon a combination of cash rent payments and interest expense on the outstanding liability, often referred to as the effective interest method. This means the interest expense hitting the P&L at the beginning of a lease term when the outstanding liability is higher than it is later in the term is greater than it is later in the term. The Right of Use Asset under a Type A lease is amortized off of the balance sheet via a straight line amortization method. Hence the asset is reduced by the same amount every month during the term, and that amortization expense runs through the P&L. The sum of the amortization expense and the interest expense represents the P&L impact from the capitalized lease obligation. Important to note: All leases under IASB will be Type A leases and many leases which are presently considered Operating Leases under GAAP will likely be treated as a Type A lease. Any lease which is presently treated as an Operating Lease and is transitioned to a Type A lease will likely show a significant increase in reported expense during the early years after the transition, which in most cases will be in the 2019 timeframe. Type B (Operating) Leases As with a Type A lease, the lease liability under a Type B lease is drawn down during the term of the lease based upon a combination of cash rent payments and interest expense on the outstanding liability. This means the liability balance during the term of a Type B lease will be the same as it would be if that same lease was classified as a Type A lease. However, this is where the similarities between Type A and Type B leases end. The Right of Use Asset under a Type B lease is amortized off of the balance sheet during the term of the lease, but the way in which it is amortized bears no resemblance to Type A s straight line amortization. Rather, it is a plug equal to the difference between Type B lease s straight line rent expense and the interest expense for that period. Since interest expense will be decreasing as the liability is paid off during the term, this means amortization expense will be increasing at the same rate as the decrease in the interest expense. Moreover, while the expense reported on the income statement for a Type B lease is straight line rent expense (i.e., similar to today s operating lease and above the line for EBITDA purposes), the interest and amortization components are required to be disclosed in the notes to the financial statements. So, while both Type A and Type B leases will be recorded on the balance sheet, the way in which they affect shareholder equity and the income statement differ significantly, with Type A leases having a worse effect on shareholder equity, but a better effect on EBITDA results throughout the lease term. Similarly, Type A leases will have a worse impact on net income during the first half of a lease term, and then a better impact on net income during the latter half of the lease term as compared against the impact of the same lease if classified as a Type B lease.

4 Lease Classification under US-GAAP So which kind of lease do you have Type A or Type B? The FASB has provided guidance around this question, and essentially replaces the bright line tests of existing capital lease tests to substitute them with more subjective or principle-based rules. In short, a lease will be classified as a Type A lease if: The lease term, as affected by any renewal or termination options which present the tenant with a significant economic incentive to exercise the option(s), represents the major part of the underlying asset s remaining economic life. This criteria is excluded for leases that commence at or near the end of the underlying asset s economic life which is measured as the final 25% of the asset s economic life. The present value of the lease payments during the lease term (as altered by the above-referenced options), is substantially all of the fair value of the underlying asset. The lease includes an option for the tenant to buy the building, and the tenant has a significant economic incentive to exercise that option. Any changes to lease term or company s option to purchase the underlying asset will require a reassessment of the lease classification. The implications resulting from the classification of a lease under US-GAAP are far reaching and tenants will find they may be able to achieve certain financial results based upon the way in which the rents, term and renewal or termination options in their leases are structured and negotiated. How will Amounts be Calculated? Rent A tenant would initially measure the Lease Liability as the present value of the rent it pays during the lease term, as the term is affected either by termination options or renewal option periods for which the tenant has a significant economic incentive to exercise the option(s). The rent will be considered as the combination of: The non-contingent rent (i.e., contracted base or fixed rent plus any rent increases based on an index); plus Any termination penalties or residual guarantees that are to be paid; plus Any option payments that the lessee has significant economic incentive to exercise; minus Embedded costs for taxes and insurance will be capitalized and included as part of Rent. Allocations for all other operating costs (such as CAM, utilities, services, etc.) are to be segregated and not capitalized, but rather expensed on a year by year basis. The calculation of the Right of Use Asset uses the Lease Liability as its starting point, but is subject to two further adjustments: Deduct any lease incentives received from the lessor (e.g. tenant improvement allowances), and add Any initial direct costs incurred by the lessee (i.e. costs directly attributable to negotiating and arranging a lease that would not have been incurred without entering into the lease e.g. commissions and legal fees). Term The non-cancelable period for the lease, together with the period(s) covered by options to extend the lease if the lessee is reasonably certain, having considered all relevant economic incentive factors, that they will exercise the option(s). Some of these factors include: Terms in option period compared to market rates such as lease payments and purchase options Significant leasehold improvements Termination costs Specialized assets that are core to the company s operations Companies will need to reassess the lease term if there is a significant event or change in circumstances that are within their control. Discount Rate The discount rate used for calculating the Lease Liability, Right of Use Asset and interest expense is the tenant s incremental borrowing rate as of the date of the lease commencement. The incremental borrowing rate is supposed to be based upon the rate the tenant would have to pay to borrow funds for a comparable period on an unsecured basis. Privately held companies will be able to utilize a risk free rate, such as comparable term US Treasury rates, if their incremental borrowing rate is not easily determinable. However, a risk free rate is expected to be less than the incremental borrowing rate and that has consequences for balance sheet metrics and potentially lease classification results. Companies will be required to reassess the discount rate if the lease term changes or due to the assessment of the option to purchase the underlying asset.

5 How Leases Will Appear in Financial Statements Balance Sheet Right-of-use assets shown separately from other assets; Lease liabilities shown separately from other liabilities; Right-of-use assets arising from Type A leases separately from those arising from Type B leases; and Lease liabilities arising from Type A leases separately from those arising from Type B leases. Income Statement For Type A leases, a lessee would present the interest on the lease liability separately from the amortization of the right-to-use asset; and For Type B leases, a lessee would present the interest on the lease liability together with the amortization of the right-to-use asset as part of the single lease expense amount. Payments arising from Type B leases would be classified as operating cash flows. Disclosures FASB and IASB have proposed several qualitative and quantitative disclosure requirements with the objective of furthering transparency of the cash flows from leases. Companies will have the liberty to determine the level of detail necessary to satisfy the disclosure objective. Balance Sheet FASB AND IASB HAVE PROPOSED SEVERAL DISCLOSURE REQUIREMENTS OBJECTIVE OF FURTHERING TRANSPARENCY OF THE CASH FLOWS FROM LEASES. Income Statement

6 Other Lease Structures & Issues Subleases An intermediate lessor (such as a tenant who is subleasing to a subtenant) would classify and account for the primary lease in accordance with the lessee accounting proposals. Similarly, it would classify and account for the sublease in accordance with the lessor accounting proposals. To determine the classification of the sublease, the intermediate lessor would consider the underlying asset in the primary lease. An intermediate lessor will present both the primary lease and the sublease on a gross basis in the income statement and statement of cash flows. So they should show the accounting presentation for both the lessee (for the primary lease) and lessor (for the sublease). Sale-Leaseback Transactions A sale-leaseback transaction involves the sale (or transfer) of an asset and its subsequent leaseback by the seller. It has been proposed that if the requirements for the recognition as a sale are met, then a sale and leaseback of the underlying asset would be recognized; otherwise, the transaction would be accounted for as a financing. For a sale, the Seller-Lessee will recognize a gain or loss on sale transaction based on the sale price, assuming the sale price and leaseback payments are at market rates. This gain or loss will be fully recognized in the year of the sale, rather than deferred and spread over the leaseback term as happens in most circumstances under current accounting rules. Seller-Lessees shall disclose information on their sale-leaseback transactions including the principal terms of the arrangements, as well as any gains or losses recognized. Under FASB s new rules, a purchase option, even at future fair market value, will cause the transaction to be accounted for as a financing of the property rather than a sale and leaseback. For transactions at above or below market rates, the company will treat the below market deficiency as a prepayment of rent and above market premium as additional financing.

7 What does this mean for corporate occupiers? Corporations need to review and update lease databases and technology systems to capture and calculate all the data to be required for the new reporting standards. This will need to be a joint effort of real estate, information technology, finance, and accounting groups. The size of the Balance Sheet will increase. Some expenses will be accelerated and therefore increased in early years. Compliance with existing financial covenants will likely be harmed. Expenses charged to business units may change significantly. Minimal changes to corporate credit ratings or borrowing costs are expected. The rating agencies have said they fully understand leasing and how corporations use leases, so a change in the way the leasing is presented will not change the way the rating agencies underwrite the companies that use leasing. Corporations may want to re-evaluate their lease vs. ownership model and criteria. More attention will be paid to lessor financing, especially in single tenant buildings. In single tenant buildings, the cost of funds should become more relevant than rent per square foot. Leases of intermediate terms may become less attractive, especially for single tenant buildings, as they may have a calculated Lease Liability (i.e. the present value of the rents) which substantially exceeds the cost of the underlying property. In such cases, in the early years of a lease, the reported expense of leasing would likely be significantly higher than the reported cost of ownership. transition process with their accounting departments. This will likely change the way many corporations chose to structure leases, M&A activities, and other transactions. Understanding, quantifying and, to the extent possible, mitigating the less desirable impacts from these new rules will require knowledge, resources and an action plan. Cresa has the knowledge and resources, both in terms of people and technology, to help companies implement their respective action plans to deal with these new standards. We have observed that firms having the most success in preparing for these new accounting rules all have a plan that includes the following four steps: Step One: Conduct a strategic review of your lease portfolio in order to (A) begin building a framework around how your firm will deal with the more subjective issues in these new standards, including topics related to significant economic incentives in renewal and termination options, evaluating a property s remaining economic life, and (B) quantify and understand the way in which a representative sample of your leases would be reflected on your financials under these new rules. Step Two: Get Systems and Technology upgraded so you capture the data needed. This will be a joint effort by corporate teams from real estate, information technology, equipment leasing, finance, and accounting. Step Three: Get internal operating teams and systems aligned for functional integration and expanded workload. Step Four: Update corporate strategy regarding financing decisions, operating requirements, and real estate decision making. Getting Prepared It is worth noting this is predominantly a real estate driven issue, as the overwhelming majority of the nominal value of all leases (i.e., equipment and real estate), is tied up in real estate leases. Corporate occupiers of space will want to prepare for these changes, which will be significant, by understanding their lease obligations and making sure they have accurate data. Tenants who utilize long-term single-tenant leases may find that the rule changes impact them substantially and will want to consider different strategies of negotiating such leases, using alternative lease structures, and in some occasions opting to purchase their facilities. Corporate real estate departments need to be actively engaged in this transition and will likely co-lead this Learn More Cresa Capital Markets Brant Bryan bbryan@cresa.com