January 24th, 2012
After an extended 2011 comment period to the initial lease accounting Exposure Draft (ED), the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) intend to release a revised ED early in the second quarter of 2012. The public will have opportunity to comment on this new ED for at least 120 days following the date of release. If the revised ED is released on schedule, we can expect that new lease accounting standards will be finalized in the first or second quarter of 2013 with the transition period occurring as early as 2015 or 2016.
Based on our review of the initial ED, here are some issues our negotiators and lease administrators are watching:
Financial statement preparers are likely to have to show two years of comparative data in the year of transition for all leases on the books in that transition year. So, during the two years prior to the effective date of any reporting changes, lessees will want to get a handle on applying the new standards to their books. Property Works will be in conversation with each client throughout this period; together, we will design our approach to supporting each clients’ new reporting needs.
Definition of “lease assets”: Although capital leases might be grandfathered into the current accounting standards during the transition period, after that point all leases – capital, operating, or otherwise – will be considered “leases” within the standard definition. We are watching to see whether FASB tightens the definition of “lease” or specifies any exceptions so that lessees don’t report more capitalized leases than the standards require.
Impact on Profit and Loss statements & deferred taxes: Under the current ED, all leases will be booked at the present value of remaining rents, including all renewal terms that the lessee has a strong economic incentive to exercise, offset by the asset to the lessor of the “right of use” of the property over the remainder of the lease. This results in a highly front-loaded reported cost to lessee, although such front-end costs are unlikely to reflect the actual economics of the lease over its term. Such a reporting structure will affect lessors’ reported profits, generate deferred tax assets in the early years of many lease and may make retailers appear more leveraged than they are, thereby potentially reducing a lessors’ access to capital. We’ll look for FASB revisions to this approach in the upcoming ED, as this language met with heavy criticism from commenters.
Renewal Term language matters: FASB has indicated that the definition of a lease term will probably be the contractual terms plus renewal terms that are essentially a bargain the lessor can’t refuse, but we do not yet know exactly what kinds of renewal language will trigger a renewal term being counted (and capitalized) as part of the lease term up front. Our negotiations team is evaluating approaches to negotiating renewal term language as the precise words of a lease could affect financial reporting.
Contingent rent accountability: Variable payments, such as CPI, will be capitalized by the lessee at an estimated spot rate. As the index fluctuates, this occurrence will impact P&Ls for the current period and prior period and naturally the “right of use” asset or liability, as applicable, will be adjusted for the future. Currently, it looks like percentage rent will not be capitalized unless such payments can be considered minimum payments masquerading as percentage rent. Depending on where FASB settles out, the use of CPI and the language of percentage rent provisions could be negotiation points for new leases or renewals.
Amendments to Lease Contracts after Commencement: Substantial alterations to a lease will likely result in that lease’s being deemed a new contract for financial reporting purposes, resulting in another round of front-end heavy capitalization following amendment. We will be reviewing the upcoming ED and any related guidance to determine what sorts of revisions will trigger this “new lease” status and our negotiators will be ready to manage amendments with an eye toward possible financial reporting impacts.
We are always interested in discussing how Report ms and the Property Works team can support your lease management needs in the current and future financial reporting environment. Contact your Account Manager or call us at 678-795-3830 – we look forward to hearing from you.
Post by Andrew Larrier and Caroline Branch