Click here to view the video on YouTube.

Don’t miss the discussion between Andrew Zezas of SIOR NJ and Marc Betesh of KBA Lease Services & Visual Lease.  Together they outline the upcoming changes to lease accounting under GAAP and their potential impact on commercial real estate, developers and occupants. 

Topics Include

FASB and IASB:  Who Are They and Why Are They Important?
Upcoming Changes and Reasons behind the Initiative
Treating a Lease like an Asset
The Effect of Draft Delays, Roundtables and Comment Letters
Renewal Options and Inaccurate Projections
Evaluating the Likelihood of Exercising Options and Economic Incentives to Renew
What Tenants Should Do Today

Marc Betesh, President and founder of Visual Lease and KBA Lease Services, will be speaking about FASB’s upcoming lease accounting changes at the NRTA Annual Conference on Septermber 12th, 2011.  Marc’s presentation “FASB:  The Conceptual Background & the Effects On Future Lease Negotiations,” will help retailers address tremendous concern across the real estate industry.

In a prior post covering the forthcoming FASB changes to lease accounting, we reported that the FASB and IASB (the “Boards”) were more concerned with the quality of their final decision than the proposed timing.  According to industry chatter, it is looking quite likely that the Boards plan to ‘put their money where their mouth is’ as they continue to re-deliberate crucial issues based on the steady flow of industry opinion and data received from comment letters, roundtables and outreach initiatives.  This article will focus on some of the more substantive decisions made (or re-made) in lessee accounting to date.

Timing

For the better part of a year, the real estate community has been highly anticipating the pronouncement of the final standards by Q4 2011, subsequently to come into effect sometime in 2013.  Concerns surrounding the complexity of implementation have pushed the probable date back further to 2015.  However, there now is word that the Boards may take the Leases proposal down the same road as the Revenue Recognition project and re-expose the draft of the proposed new rules.  While this is not yet a certainty, a re-exposure would essentially take us back to day one and substantially elongate the implementation timeline.

One or Two Accounting Approaches for Lessees?

The Boards, after receiving many comments regarding this controversial portion of the proposal, had tentatively agreed to recognize the fact that not all leases are entered into as a financing vehicle for an asset purchase. Accordingly, they established two forms of leasing – “finance leases” and “other-than-finance” leases.  The latter, while not completely devoid of some financing element, recognized that the primary purpose of the lease is to create economic flexibility, such as to mitigate the risk of ownership and/or outsource significant activities principally related to maintenance and administration of an asset.

Perhaps the Boards felt that determining which leases were to be considered a finance-type as opposed to an other-than-finance-type was too onerous because, for whatever reason, they have reverted back to a single accounting approach for all leasing transactions.  This current approach, which is the same as the approach originally provided for in the Exposure Draft (“ED”), requires lessees to:

1. Initially recognize a liability to make lease payments and a right-of-use asset, both measured at the present value of the lease payments.
2. Subsequently measure the liability to make lease payments using the effective interest method.
3. Amortize the right-of-use asset on a systematic basis that reflects the pattern of consumption of the expected future economic benefits.

Because the liability will need to be amortized over the lease term like a mortgage loan, the annual interest expense is front-loaded, thereby requiring lessees to report higher lease expenses in the earlier lease years.

Options are In,  “More Likely Than Not” is Still Out

As previously reported, the Boards have recognized the near administrative impossibility of determining when it is “more likely than not” that an option will be exercised. To recap, the revised definition now reads:

“The lease term is the non-cancellable period for which the lessee has contracted with the lessor to lease the underlying asset, together with any options to extend or terminate the lease when there is a significant economic incentive for an entity to exercise an option to extend the lease, or for an entity not to exercise an option to terminate the lease.”

Therefore, at initial measurement and/or subsequent re-measurement, the determination as to whether a “significant economic incentive” exists will include, among other factors, the economics of the option compared to current market conditions, as well as whether significant commercially advantageous terms exist.

Reassessment

Reassessment of the lease term would only occur when there is a substantial change in relevant factors that would impact whether a lessee would have, or no longer have, a “significant economic incentive” to exercise any options to extend or terminate the lease. A lessee should take contract-based, asset-based and entity-based factors into consideration when reassessing whether a “significant economic incentive” exists.  These factors, when coupled with the tentative suggestion that in making this determination lessees should not consider changes in market rates after lease commencement, seems to suggest that the Boards are leaning toward a more subjective form of decision-making process – relying on external forces  as well as internal business decisions – as opposed to a more objective one whereby a “significant economic incentive” is measured by market forces and current pricing models (somewhat like valuing an “in the money” option).

In any event, this tentative modification to the ED would require a remeasurement of the asset/liability/income/expense in the first reporting period occurring after the “significant economic incentive” becomes apparent, notwithstanding that the lease required notice date has not yet arrived.

The Separation of Lease and Non-Lease Components

The Boards’ more definitive stance now dictates that an entity be required to identify and separately account for the lease and non-lease contract components.  Lessees are instructed to allocate payments as follows: if the purchase price of each component is observable, payments should be allocated on the basis of the relative purchase price of each distinct component; however, if purchase prices are not observable, all payments required by the contract should be accounted for as a lease.

The Boards have noted that, in consideration of the relevance of guidance in other projects such as revenue recognition, application guidance on how a lessee should determine what would constitute an observable price shall be provided.

When to Start: Inception versus Commencement

In response to questions concerning when to begin measuring lease assets and liabilities, the Boards have tentatively proposed that both lessee and lessor should recognize assets and liabilities (and derecognize any corresponding assets and liabilities) using a discount rate calculated at the date of lease commencement. The lessee should use the discount rate the lessor charges the lessee or, in the alternative, the lessee should apply its own incremental borrowing rate.

Furthermore, the Boards aim to capture Initial Direct Costs (those costs directly attributable to negotiating and arranging a lease that, but for the lease transaction, would not have been incurred) by requiring lessees to capitalize such costs by adding them to the carrying amount of the leased asset.

Lessees with leases which, at the date of commencement have a maximum possible term (including options to renew) of 12 months or less, need not recognize the lease asset or liability.  The Boards have tentatively decided that these short-term lease payments should be recognized in profit or loss on a straight-line basis over the lease term.

Looking Forward

While the ultimate decision may be a long-way off, there are sure to be more substantive changes, and changes to those changes, in the future; we will diligently keep you apprised of the path of the FASB/IASB Lease Proposal.

Additional Resources

• Video: Marc Betesh Talking FASB with Duke Long
• FASB Q&A with Realtor Magazine
• Lease Accounting Software and Services

A new forum for discussing issues in corporate and commercial real estate has emerged – Twitter!  A good friend of ours, Jason Sandquist, has started a weekly tweet-chat session to discuss issues pertaining to end users and services providers in the commercial real estate space.  Each week a different moderator facilitates a discussion with hundreds of real estate professionals from around the world.

The chat takes place every Friday at 2pm EST.  To participate:

1. Sign up for a Twitter account
2. Go to www.crechat.co for a filtered view of the conversation.
3. If you use Tweetdeck or Hootsuitesimplify the experience by filtering the #crechat hashtag into one stream or “column”.
4. For additional info check out 12 Most Helpful Tips for Conversing in a Twitter Chat.

We are especially excited for this week’s chat because Visual Lease’s COO, Chris Werely , will be moderating the discussion!  He will be focusing on this upcoming changes to lease accounting under the FASB.

Realtor magazine, the official magazine of the National Association of Realtors, talks FASB with Marc Betesh.

In the article, titled The Facts On FASB, Realtor Magazine’s Mariwyn Evans questions FASB’s proposed changes to lease accounting rules.

_____________________

Proposed changes by the Financial Accounting Standards Board to lease accounting rules could make record-­keeping a lot more complicated and lease negotiation more difficult, says Marc Betesh, president of KBA Lease Services and Visual Lease in Woodbridge, N.J.

What are the changes that the Financial Accounting Standards Board (the private-sector group that sets rules and reporting standards for ­accountants) is proposing for leases?

The fundamental change under FAS Topic 840 is that all off–balance sheet transactions involving operating leases, which includes most real estate leases, will be eliminated. Currently, companies don’t show operating leases for real estate on their financial statements, except in footnotes.

How will companies account for their leases if the new rules are adopted?

Leases will appear on a company’s financial statement as though the company had purchased and financed the leased asset. The lease will be shown as a “right-of-use asset” with a corresponding liability for the rent payments and any direct costs like brokerage commissions. The actual figure used will be the net present value of the rent calculated at the interest rate it would cost the company to borrow money. The liability appears the same way, although direct costs are excluded. As the company makes rent payments, each payment is recorded as a payment of principal (a portion of the NPV of the asset) and interest. This amortization requirement could mean that a disproportionate amount of the rental liabilities will shift to the first years of a lease.

Why are the changes eliciting such controversy?

There is a lot of debate on two points—operating expenses and lease options. The right-of-use asset is supposed to cover only the pure use of the space, not the cost to service it. So companies will have to separate out service costs like common-area maintenance charges, taxes, and insurance from the right to use the space. Stripping out these costs will be easy with a pure triple-net lease since the tenant pays all those costs separately. It’s more muddled with a modified gross lease since the landlord pays these costs for the first, or base, year of the lease.

What is the issue with lease options?

Under the new rules, tenants will have to consider how likely they are to exercise lease options from the first day they sign a lease. If they are likely to extend a lease, they have to include the option term and the option rent in their calculations. Making the option decision so early is very subjective and seems to undermine the purpose of the rule change, which is to provide more transparency and reliability in financial statements.

To make things even more complicated, the tenant also has to re-evaluate these probabilities on a regular basis and recalculate the amortization to reflect any changes.

How could these changes affect the overall leasing climate?

Under the new proposal, tenants may prefer shorter leases, which will be problematic for landlords that need longer leases to secure financing or sell a property at a higher price.

When will the proposals be finalized?

It seems likely that the proposals will be enacted sometime this year and go into effect a year or more later.

Duke Long interviews Marc Betesh, President and CEO of Visual Lease, about upcoming FASB changes at Corenet’s Chicago conference.

Click here to view the video on YouTube.

Tomorrow’s webinar will explore the underlying theory behind the proposed FASB changes.  IFMA, a professional association for facility management professionals,  and Visual Lease’s President, Marc Betesh, will outline the potential ramifications and offer advice as to best prepare for the impact.

Topics Include:

1. Why the Changes Were Proposed
2. What Will Change
3. Impact on Lease vs. Buy Decisions
4. Treatment of Gross vs. Net Leases
5. The Most Current Updates/Deliberations/Alterations Made to the Original Exposure Draft
6. How to Start Preparing Now

Background:
Last August, the Financial Accounting Standards Board (FASB) sent shockwaves through the commercial real estate world when they proposed significant changes to how leases must be recorded in a company’s financial statements.  Although the Boards continue to deliberate, every major company (any company that follows GAAP) will be impacted by the upcoming changes.  At a minimum, substantial attention and manpower will be required to comply with the new rules.  But the changes could also impact such decisions as whether to lease or buy or how buildings will be serviced.

In prior Lease Tips about the forthcoming changes, we reported that the FASB and IASB (the “Boards”), promised to consider the numerous comments they received regarding the proposed rule changes detailed in their joint Exposure Draft (ED) dated August 17, 2010. That process is underway and significant positive changes to some of the more controversial and costly proposals have already been tentatively agreed to.

Lease Term to Continue to Include Options,  But on a Revised Basis 

The ED currently requires that the lease term include option periods if it is “more likely than not” that the options will be exercised. This determination would need to be made at lease inception and for each subsequent reporting period and the reported asset/liability/income/expense amounts changed when circumstances change affecting the prior determination. This would have caused an administrative nightmare and most of the determinations would be highly subjective, if not outright guesses.

When Options Would Be Included 

Hearing the outcry, the Boards have tentatively agreed to the following revised definition regarding how the lease term will be determined by both lessees and lessors:

“The lease term is the non-cancellable period for which the lessee has contracted with the lessor to lease the underlying asset, together with any options to extend or terminate the lease when there is a significant economic incentive for an entity to exercise an option to extend the lease, or for an entity not to exercise an option to terminate the lease.”

Therefore, at initial measurement and/or subsequent re-measurement, option periods reasonably certain to be exercised should be included in the lease term. To make this determination, among other factors, the economics of the option will need to be compared to current market condition, and if significant commercially advantageous terms exist, the lease term should include the option period.

What remains unclear is whether this is a objective or subjective decision.  That is, is it that there is a significant economic incentive inherent in the option (does the option present a compelling incentive to be exercised because of market forces), or is it that it is reasonably certain that the lessee, given its business condition, will exercise the option.  We intend to further communicate with the Boards on this issue.

Frequency of Reassessment 

The Boards also tentatively agreed that a lessee and a lessor should reassess the lease term only when there is a significant change in relevant factors such that the lessee would then either have, or no longer have, a significant economic incentive to exercise any options to extend or terminate the lease.

Therefore, it would appear that the goal of this modification to the ED is to only require the inclusion of lease options when the economic benefit of exercise becomes clear and is significant. These conditions may, or may not, present themselves prior to the date upon which the lessee must notify the lessor that the option is being exercised. In any event, this tentative modification to the ED would require a remeasurement of the asset/liability/income/expense in the first reporting period occurring after the significant economic incentive becomes apparent, notwithstanding that the lease required notice date has not yet arrived.

This revised definition of the lease term should significantly reduce the administrative burdens of complying with the new rules and make the determinations regarding exercising options more objective, as they will be based on changes in current relevant economic factors. 

Most Leases to be Considered “Finance” Leases and Capitalized

The ED currently considers nearly all leases to be finance leases, thus requiring the lessee to report a right-of-use (ROU) asset and liability to make lease payments on its balance sheet. Instead of annual straight-line rent expense being reported on the income statement, the ED currently requires the annual reporting of straight-line depreciation of the ROU asset plus interest expense for carrying the liability to make lease payments. But because the liability will need to be amortized over the lease term like a mortgage loan, the annual interest expense is front-loaded, thereby requiring lessees to report higher lease expenses in the earlier lease years.

The Boards received many comments regarding this proposal, as the front-loading of reported expenses [that, from a cash basis, is not actually occurring] could have a negative impact on many lessees, especially those in start-up situations. To address all the concern, the Boards have tentatively agreed to recognize the fact that not all leases are entered into to effectively finance an asset purchase. In these “other-than-finance” leases, although there is some finance element to the transaction, the primary purpose of the lease is to create economic flexibility, such as to mitigate the risk of ownership and/or outsource significant activities principally related to maintenance and administration of an asset.

To further recognize the distinction between a finance and other-than-finance lease, the Boards have tentatively agreed that the other-than-finance leases will not be required to report front-loaded income/expense in the earlier lease years, but rather show straight-line recognition similar to today’s “operating” leases. Although a right-of-use asset and liability to make lease payments will apparently still need to be reported on the balance sheet for these other-than-finance leases, the front-loaded interest expense problem will be eliminated.

How to determine which leases are finance-type, as opposed to other-than-finance-type, remains an open issue. The Boards tentatively decided to establish new indicators to distinguish a finance lease from an other-than-finance lease and their staffs are currently working on establishing these indicators.

The Separation of Lease Payments from Payments for Services Received

The Boards are still contemplating this issue. Current GAAP already requires the separation of all lease and non-lease cost components. However, during the recent FASB/IASB roundtables, investors/lessors appeared to favor the non-separation of service costs, while lessees favored the annual expensing of those service costs that are distinct and can be easily identified. A recent paper by the Boards’ staff indicates that this topic is currently being studied in greater detail and the staff’s recommendations regarding the appropriate accounting treatment for these service costs will be presented at future Board meetings.

We will keep you apprised of any further developments regarding this very important issue for the real estate industry.

Visual Lease’s management team, along with Grant Thornton recently hosted a webinar to address the impact on corporate real estate under the FASB/IASB’s proposed lease accounting changes.

The presenters include some of the country’s top real estate lease experts, Marc Betesh and Lou Ferro, as well as Gary Illiano, National Partner at the CPA firm Grant Thornton.

If you were not one of the hundreds who attended, and would like to watch the replay and download the slides, it is now available. Please click here or on the image below.

Marc Betesh and Christopher Werely will be interviewed by crePodcast’s Duke Long and Jason Sandquist on February 23^rd.  CrePodcast (Commercial Real Estate Podcast) covers news from every aspect of the real estate industry and features real conversation from industry leaders around the world.  Past interviews include Stephen Spooner, Executive Chairman of OSCRE, Mike Manning, VP of Marketing at LoopNet, and Garret Krueger from ROFO.  An archive of past podcasts is located here.

The February 23^rd podcast will focus on the upcoming lease accounting changes and what can be done now to prepare.  This interview continues a string of interest in KBA’s expertise on this topic from trade associations, service providers, and major corporations.

Duke Long is the owner of The Duke Long Agency in Indianapolis, IN and is the author of the popular one of the most popular real estate blogs.  Jason Sanquist is a Real Estate Client Advisor at Adam Commercial Real Estate in Minneapolis, MN.