Key Accounting Changes in Store for Investors, Tenants Alike

By Howard Roth, Global Leader-Real Estate, Ernst & Young L.L.P.

Recently, the International Accounting Standards Board and the Federal Accounting Standards Board of the United States released the long-anticipated exposure draft. The exposure draft does not yet propose a specific effective date; instead, the effective date will be considered as part of another project for all major joint projects underway.

The Proposed New Leasing Model

The proposed new accounting for leases model is a fundamental change to lease accounting that requires all parties to lease contracts to change the way they think about leases. Though the exposure draft addresses the criticisms of current lease accounting and forces the recognition of the right-of-use asset and obligations inherent in a lease, it provides new complexity to accounting for leases. The proposed model provides a single accounting model to be applied to all leases and effectively eliminates the classification requirements of the current model, that is, no more operating or capital leases. Generally, all operating leases under the current model will be brought “on balance sheet” by lessees and lessors by recording their right to use the underlying asset (right-of-use asset) and their obligation to make lease payments (lease liability).

US GAAP vs. IFRS: Differences Still Exist

The International Accounting Standards Board has provided a scope exception for lessors with investment property recorded at fair value in accordance with the fair value option in IAS 40, Investment Property. As United States generally accepted accounting protocols does not have a similar fair value option, real estate companies that report under U.S. generally accepted accounting protocols are currently still within the scope of the exposure draft. It should be noted that the board is considering a fair value possibility for investment property under U.S. generally accepted accounting protocols, with an exposure draft on that topic expected later this year.

Under the proposed leasing model, landlords will be required to adopt one of two models for each lease, depending on if the lessor retains exposure to significant risks or benefits.

• The “performance obligation approach” under which the landlord records – in addition to the investment property – a lease receivable, and an equivalent liability representing the lessee’s right to use the underlying property;

• The “derecognition approach” under which the landlord must split his investment property between a lease receivable asset and the residual value of the property.

The performance obligation approach will be used when the landlord retains the significant risks or benefits associated with the leased asset. Otherwise, landlords must identify that part of the investment property they no longer control and “derecognize” it from the balance sheet. This approach will give rise to an immediate (day one) profit or loss.

What Are the Possible Business Impacts?

The requirement for lessees to record all leases on their balance sheets may result in a shift in lessee behavior to enter into shorter-term leases to minimize the impact to their balance sheets and income statements.

• Shorter leases could conversely result in a shift in pricing, as lessors take on more rollover risk.

• The possibility of shorter lease terms and, therefore, an increase in the uncertainty around lease cash flows, could adversely affect the valuation of real estate for investors. Uncertainty in cash flows would not likely be viewed favorably by potential lenders in a refinancing scenario.

• As lessees will no longer record rent expense, but rather interest and amortization expense, any measurements that are based off net income or earnings measures will be impacted. For instance, earnings before interest, taxes, depreciation and amortization will improve, but covenants such as interest coverage ratios could be adversely impacted. Consideration will have to be given to other contracts that utilize earnings measures, such as compensation agreements, and the effect on such arrangements.

• At adoption, the lessee and lessor (under the performance obligation model) will be required to gross up their balance sheets by the present value of the expected lease cash flows over the lease term.

• Any debt covenants or regulatory requirements that are based on debt levels such as minimum liability balances and debt to equity ratios could be adversely affected.

• With the possible impact to debt covenants, companies will have to negotiate amendments to lease agreements to consider the new leasing model. Companies may be hesitant to approach lenders with such a request in this uncertain credit environment.

• The new leasing model requires significant assumptions, including the probability of exercising extension and termination options and contingent rentals. Companies will be required to develop processes and controls for identifying such estimates which may increase the time involved in the reporting process.

• Companies will need to consider changes to the processes and technology required to not only monitor changes in estimates, but to gather and compile the information needed to determine the expected lease cash flows.