the new lease accounting standard and you whitepaper

1 The New Lease Accounting Standard and You

Part 1: Introduction The U.S.-based Financial Accounting Standards Board (FASB) and the European-based International Accounting Standards Board (IASB) are jointly preparing a new standard for lease accounting. For many years there has been general agreement in the accounting and investment communities that a revised lease accounting standard was needed. FASB and IASB have been working diligently over the last few years to create this new standard.

While the new lease accounting standard has not yet been issued, much of what is likely to appear in the new standard is detailed in a Discussion Paper released by FASB in March of 2009. The primary objective of the new standard is to recognize all leases as obligations that should be included on company balance sheets. Under current lease accounting rules, leases categorized as operating leases are not included on the balance sheet.

The U.S. Securities and Exchange Commission (SEC) has estimated that approximately $1.3 trillion of operating lease obligations will be added to corporate balance sheets once the new lease accounting rules are implemented. For some large companies, the new standard will result in a multi-billion dollar impact to the balance sheet.

The proposed lease accounting standard will precipitate fundamental changes in the management of corporate real estate. Companies will need to reevaluate real estate strategy once operating leases can no longer be left off the balance sheet. New processes, systems and personnel will become necessary to comply with the standard. The lease accounting changes will create a host of ancillary effects that companies will have to address; ranging from the potential need to renegotiate existing debt covenants to the effect on internal budgeting and business unit contribution

margins. Moreover, as investors and senior executives realize the impact of leases on the balance sheet, a giant spotlight will fall on corporate real estate. Corporate real estate will become integral to discussions about corporate financial structure and performance.

Part 2: Why? When? What? How?Why is a new lease accounting standard needed?Presently, operating leases do not appear on company balance sheets even though, for many companies, these lease obligations are the single biggest category of long-term liabilities. This creates a problem because balance sheets are supposed to provide a snapshot of a company’s financial position. Ideally, the balance sheet should show what a company owns and owes. Investors, lenders, customers and others rely on the balance sheet as a primary data source to understand the financial health of a company.

The absence of operating leases on the balance sheet has an especially distorting effect on financial statements in today’s economy where many companies employ a workforce of knowledge workers who predominately work in leased space. Failing to account for these lease obligations on the balance sheet leaves a big gap in the complete disclosure of a company’s financial position. And, while it is true that companies are required to include information about their minimum lease obligations in the notes to their financial statements, this information is insufficient to provide investors with a complete picture of actual liabilities.

When will the new lease accounting standard be in place?FASB and IASB issued a Discussion Paper on lease accounting in March of 2009 in which the proposed new accounting standard was outlined. Subsequently, meetings were held to consider comments made by interested parties and to address details not covered in the Discussion Paper.

Publication Date: July, 2010Bob Cook | Corporate Real Estate Consultant

Bob Cook is a corporate real estate consultant whose focus is strategic and financial planning. Over the last 13 years, Bob has held strategic planning positions within the corporate real estate departments of Northrop Grumman, Cisco, Sun Microsystems, and JDSU. Prior to that he was a real estate developer of office high-rises in Chicago with Rubloff Inc. In addition, he has been a Senior Fellow at the National University of Singapore where he taught real estate development and international real estate. Bob holds both a Masters of Management (Finance) from Northwestern University’s Kellogg Graduate School of Management and a Masters of Architecture in Urban Design from Rice University.

The New Lease Accounting Standard and You


In the third quarter of 2010, FASB and IASB plan to issue an Exposure Draft that will outline their current vision of the new accounting rules. Interested parties can submit comments on the Exposure Draft through the end of 2010. The accounting boards plan to issue the Final Standard by the second quarter of 2011 (See Figure 1).

Although the schedule for finalizing the new standard is fairly well known, the timeframe for when the new rules will become effective is less certain. In order to afford companies the time necessary to comply with the new standard, FASB and IASB will provide a reasonable period of time between issuance of the standard and the Effective Date for compliance.

Estimates of how much time the accounting boards will give companies to comply varies, but most observers think the Effective Date will fall somewhere between 2012 and 2013.

It is important to note that the new lease accounting rules will likely require that existing leases entered into prior to the Effective Date be added to the balance sheet and be accounted for as a new lease with a start date equal to the date that the new lease accounting standard is adopted. Under this scenario, the new standard will affect any leases signed prior to the Effective Date that are still active when the lease accounting standard is implemented.

What changes are proposed with the new lease accounting standard?The following description of the new lease accounting standard is based on the Discussion Paper of March 2009 and from meetings held subsequently by the accounting boards. Some details of the final standard may vary, but fundamental changes are unlikely.

No more classification of leasesUnlike present lease accounting rules, under the new standard leases will no longer be classified as operating leases or capital leases. All leases will be accounted for the same and all leases will be included on the balance sheet (see Figure 2).

Lease vs ServiceUnder the proposed changes, payment obligations will be bifurcated into a “lease component” and a “service component”. The service component includes items like operating expense pass-throughs. Only the “lease component” will be included on the balance sheet. The service component will be expensed as incurred and accounted for on the profit and loss statement (P&L).

It is interesting to note that some service contracts might be deemed to have a “lease component” that must be capitalized. For example, a long-term logistics-support contract that dedicates warehouse space to a customer would require that the payments made to the logistics support provider be bifurcated into “lease” and “service” components and accounted for accordingly.

“Likely” lease obligation Under the new lease accounting standard, all “likely” lease obligations will be included on the balance sheet. This differs significantly from existing capital lease accounting standard that require only the “minimum” lease obligation be accounted for on the balance sheet.

For each lease that contains an option to extend a lease or buy the leased property, the likely lease obligation will need to be projected based on the likelihood that the lease options will be exercised. Also, when the option to renew sets the rental rate based on a future market rate, an assumption of that future rate would likely be required. A projection of likely lease obligations would also have to include an estimate for contingent rents. For example, in the case where a retail store’s rent is partially determined by the sales volume of the store, future sales volumes would need to be estimated in order to project the likely lease obligation.

Assumptions related to likelihood of renewal, future rental rates and contingent rents will all have to be updated periodically as business conditions and company strategies change.

Balance sheetAssets and liabilities Under the proposed lease accounting rules, leases will be accounted for as an asset and liability on the balance

Figure 1: Timeline to create new lease accounting standard

Timeline to new standard


sheet. Lease obligations will be included on the asset side of the balance sheet as ‘right-to-use assets’, and on the liability side of the balance sheet as lease liabilities. When a lease is initially placed on the balance sheet, the asset and the liability will be valued equally. This initial value will be equal to the present value of the likely lease obligations discounted at the company’s incremental cost of debt at lease signing.

The right-to-use asset will be depreciated on a straight-line basis over the lease term (i.e., the asset value will decrease by the same amount each reporting period). The lease liability will be amortized over the lease term based on an amortization schedule similar to a self-amortizing loan. With this structure, the liability will decline slower in early reporting periods than in later reporting periods.

P&L statement Under the new lease accounting standard, companies will no longer account for the rent expense as a line item on the P&L. Instead, rent obligations will be split into depreciation of the right-to-use asset and interest on the lease liability. The depreciation expense results from depreciating the right-to-use asset over the lease term. The interest expense results from an imputed interest charge on the outstanding lease liability. (The actual rent

payment is split into payment to interest and payment to principle, with the later reducing the liability carried on the balance sheet.)

Unresolved issuesAs of this writing, there are two significant issues under deliberation by the accounting boards. The first concerns sublease accounting which is entwined with deliberations regarding how lessor accounting should be treated. This issue will probably be covered in the upcoming Exposure Draft. The second issue is in regards to the Effective Date when the new lease accounting will be required. The Effective Date may not be known until the final lease accounting standard is issued in 2011.

How will companies transition to new lease accounting?The transition rules are not yet finalized, but the accounting boards have suggested a course of action. On the date a company adopts the new standard, operating leases would all be added to the balance sheet as if they were new leases on that date. Although existing capital leases will already be on the balance sheet, an adjustment may be needed to account for renewal options where rights to renew are likely to be exercised. In addition, for those companies prepared to adopt the new accounting standard prior to the Effective Date, FASB and IASB may permit early implementation.

Figure 2: Present vs New Lease Accounting

Present vs New Lease Accounting

Present New


Part 3: New Lease Accounting ExampleLet’s take a look at an example of how the new lease accounting standard will affect financial statements. Consider a four-year lease with a rental rate of $1,000 per year. Under present accounting rules, this lease would most likely be classified as an operating lease. As such, it would have the following impacts on financial statements: ▪ No impact on the balance sheet ▪ P&L impact would simply be a “rent expense” of $1,000

per yearNow let’s look at how this lease would be accounted for under the new lease accounting standard.

Balance SheetAt the signing of the lease, the present value of the four years of payments would go onto the balance sheet, both as an asset and a liability. In this case, assuming a discount rate of 6%, the present value would be $3,465 (see Figure 3).

Using straight-line depreciation, asset values decline evenly over the life of the four year lease at a rate of $866 per year. The lease liability declines at a slower rate than the asset value based on the amortization schedule that divides the $1,000 annual payment into an interest payment and a principle payment that reduces the lease liability.

Important to note: Initially, the impact on company net worth (i.e. the difference between assets and liabilities on the balance sheet) is zero. In subsequent periods, however, the impact on net worth will be negative. The deteriorating balance sheet metrics may be material for companies heavily dependent on operating leases. For example, the increased debt to net income ratio (aka the debt-coverage ratio) may violate debt covenants and provide the lender with a legal right to raise interest rates or even call in a loan early.

P&L Statement For this lease example, the P&L statement will show a depreciation expense of $866 per year over the life of the lease. In addition to the depreciation expense, there will also be an interest expense on the outstanding balance of the lease liability. The first year interest would be $208 and each subsequent year the interest expense would be slightly lower as the lease liability is reduced. With the current lease example, the interest expense would be only $57 in year four.

Important to note: During the first half of the lease term, P&L expenses associated with the lease will be greater than the rent expense under current lease accounting rules. In the second half of the lease the opposite is true; P&L expenses associated with the lease will be less than the rent expense under the previous rules (see Figure 4). This phenomenon is more pronounced with longer lease terms. The P&L expenses associated with leases also will be larger in the early years of the lease term than they would have been under present lease accounting, causing budgeting challenges when the standard is first adopted.

The silver lining: Interestingly, the new lease accounting will have a positive effect on Earnings Before Interest Taxes Depreciation and Amortization (EBITDA), which many companies use as an important measure of profitability. Under the new lease standard, EBITDA will improve because the interest and depreciation expenses that will replace today’s rent expense are, by definition, not included in the EBITDA calculation.

Figure 3: Lease Example with New Accounting Standard

Year 1 2 3 4

Cash Flow 1,000 1,000 1,000 1,000

Year 1 2 3 4

Asset 3,465 2,599 1,733 866

Liability 3,465 2,673 1,833 943

Year 1 2 3 4

Depreciation 866 866 866 866

Interest 208 160 110 57

Total 1,074 1,027 976 923

Year 1 2 3 4

Begin Balance 3,465 2,673 1,833 943

Interest 208 160 110 57

Payment 1,000 1,000 1,000 1,000

End Balance 2,673 1,833 943 0

CashFlow

BalanceSheet

at beginningof year

P&LExpense

LeaseLiability

Acctg

Pres

ent

Valu

e (1

st y

ear)

Inte

rest

Exp

ense

Begi

nnin

g Ba

lanc

e

t

t

t

t

Illustrative lease - Length: 4 years | Net Rent: $1,000/year | Discount rate: 6%

Illustration of New Lease Accounting

Year 1 2 3 4 Total

Present Accounting - Rent expense

$1,000 $1,000 $1,000 $1,000 $4,000

New Accounting - Interest and Depreciation expense

$1,074 $1,027 $976 $923 $4,000

New Accounting -Interest andDepreciation expense

Year

P&L

Expe

nse

1 2 3 4

$1,100

$1,050

$1,000

$950

$900

P&L Expense: Present vs New Lease Accounting

Figure 4: P&L Expense - Present vs New Lease Accounting

Present Accounting - Rent expense


Part 4: New Visibility, New ResponsibilitiesThe spotlight on real estateThe new lease accounting standard will effectively shine a huge spotlight on corporate real estate. The size of lease obligations will become very visible since leases will have their own line items among the other assets and liabilities on the balance sheet.

The size of lease obligations will be very large for many companies. Retailers and restaurant-chains will post some of the largest lease obligations. Some of these companies will add more than $10 billion of liabilities to the balance sheet. The size of lease obligations that non-retail companies post, although smaller than that of retailers, will be eye-opening to investors. While it is widely understood that many retailers lease a significant percentage of their real estate, the lease obligations of non-retailers have historically attracted little attention.

Companies with a large number of knowledge workers sitting in leased offices will be particularly affected by the new standard. Several companies in the tech industry will add more than $1 billion of obligations to their balance sheets (see Figure 5). No matter the size of the company, the value of leases added to the balance sheet will be surprising to many. For many companies, lease liabilities will exceed those of any other type of long-term liability on the company balance sheet.

The spotlight on youThe spotlight on leases will extend to those who are involved in managing or accounting for the real estate portfolio. As lease obligations become more visible, investors will begin to ask questions about how lease obligations are managed and company executives will direct these questions to corporate real estate departments.

The new attention paid to corporate real estate will deliver a mixed blessing. The questions asked by investors and executives may be hard-hitting and difficult to answer. At the same time, the corporate real estate function will gain new-found respect from senior executives and some corporate real estate executives will be included in top strategic discussions related to company cost-structure and profitability. Moreover, those involved in corporate real estate will find a host of new responsibilities and challenges including the following:

▪ Rethinking strategy ▪ Reformulating budgets ▪ Communicating the implications of the new

accounting to stakeholders ▪ Creating and managing processes to comply

with the new standard

Rethinking real estate strategyPortfolio planningLong-term real estate portfolio planning will take on new meaning as a result of the new lease accounting. Corporate real estate professionals will make many forward-looking assumptions and create documented plans to justify assumptions and withstand the scrutiny of auditors. Auditors will scrutinize companies that assume that lease options will expire without adequate justification since this tactic may be adopted in order to minimize the asset value of the obligation. Conversely, auditors might also be alerted when companies assume that most lease options will be exercised since this could be a tactic to improve financial performance at a later date by reversing the renewal assumption when the liability reduction from the assumption change is likely to exceed the asset reduction.

While auditors scrutinize lease term assumptions, executive management will watch to make sure lease assumptions are as beneficial to the balance sheet as legitimately possible. In short, those involved in the lease assumption process can look forward to many people looking over their shoulders.

The only way to show that the renewal assumptions are genuine is through documented portfolio plans that result from sound planning processes. Issues that affect the size and composition of the company real estate portfolio (relocations, consolidations, outsourcing of manufacturing and business processes, alternative workplace strategies, shift to on-

Figure 5: Estimated balance sheet impact for selected major companies

Walgreen $35.0 B

CVS 27.0 B

Wal-Mart 13.1 B

McDonald’s 10.4 B

Home Depot 8.5 B

Kroger 7.0 B

A sampling of Retail and Service companies

Hewlett-Packard $3.4 B

Google 2.5 B

Microsoft 2.4 B

IBM 1.5 B

Cisco 1.4 B

A sampling of “Tech” companies

Future operating lease obligations to go on balance sheets


line retailing, etc.) will need to be addressed in the light of the new lease accounting standard. Longer-term planning decisions, that were often neglected in the past, may be required to comply with the new rules.

Own-vs.-leaseA key strategic issue that needs to be revisited as a result of the new lease accounting standard is the own-vs.-lease question. Companies that have avoided property ownership in order to keep assets off of the balance sheet, will need to remove this consideration from the decision making process since all leases will now end up on the balance sheet.

It is true that no change will be necessary for companies that base own-vs.-lease strategy solely on economics as represented by projected cash flows. Few companies, though, totally ignore the financial statement impact of large own-vs.-lease decisions, and so most will have to readdress this question based on the proposed lease accounting standard.

Lease DurationDecisions regarding lease term may also need to be reevaluated as a result of the new lease accounting standard. For example, in today’s “Tenants’ Market”, relatively low rental rates provide an incentive for tenants to sign long-term leases in order to lock in low rental rates. The new lease accounting rules discourage long leases since, all else being equal, a longer lease will generate a higher initial P&L expense than a shorter lease. And while the expense will gradually decrease and eventually be lower than the rent expense under current accounting rules, company decision-making is often biased towards improved short-term results. The lease term, therefore, takes on new importance with the new lease accounting rules.

Managing budget challenges Once the new lease accounting standard are implemented, companies will experience an increase in aggregate lease-related expenses. This increase is likely to continue for a number of years until a large part of the portfolio is renewed. Corporate real estate departments are going to find themselves with a difficult budget challenge. The size of the challenge depends upon the structure of lease expirations in the portfolio, but most companies will experience an increase in lease-associated expenses of between 5% and 10% (see Figure 6).

Those with budget responsibilities will spend a lot of time reconciling the new required real estate budgets to the old budget and explaining to what extent the budget increase is due to the new accounting. Executive management may also request that real estate savings be identified to offset the lease-accounting induced expense increases.

Communicating to those affectedThe new lease accounting standard will affect many groups in the corporation beyond the real estate group. The corporate real estate group will likely be expected to identify who will be affected and educate each group on the changes and potential effects of the new lease accounting standard. The affected parties will include people such as business unit leaders who may see their real estate charge-backs increase and treasury managers who will have to explain the company’s deteriorating financial statement metrics to debt-holders. The scale of the communication program required should not be underestimated.

Ensuring complianceOf all the new responsibilities arising from the new accounting standard, compliance may be the most time-consuming and daunting. Initially, the effort required to comply with the new standard will be huge. Corporate real estate departments will face additional pressures: ▪ Ensure all relevant lease data is collected and is accurate ▪ Create and maintain sound assumptions about lease

renewals, rental rates, contingent rentals, etc. ▪ Create and maintain processes to collect lease data and

assumptions ▪ Manage the various steps required to properly add leases

into the financial statements

Figure 6: Budget challenge for existing leases

Remaining Lease Term

Present Accounting

– Rent Expense

New Accounting – Interest and Depreciation

Expense

PercentageIncrease

1 year $1,000 $1,000 0.0%

2 year 1,000 1,027 2.7%

3 year 1,000 1,051 5.1%

4 year 1,000 1,074 7.4%

5 year 1,000 1,095 9.5%

6 year 1,000 1,115 11.5%

7 year 1,000 1,132 13.2%

8 year 1,000 1,149 14.9%

9 year 1,000 1,164 16.4%

10 year 1,000 1,178 17.8%

15 year 1,000 1,230 23.0%

The budget challenge:Increase in P&L expense in first year of new accounting


▪ Automate processes where possible with technologyLease DataWith the new lease accounting rules, real estate departments will need processes and tools to improve the completeness and accuracy of lease data collected. Large companies with worldwide operations and/or autonomous business units will have an especially difficult time in verifying that the lease inventory is complete. Companies must collect accurate information for each and every lease in the company’s real estate portfolio.

Key lease data to collect and manage: ▪ Fixed rental obligation ▪ Contingent rental terms ▪ Lease start date and expiration date ▪ Structure of utility and CAM charges ▪ Terms of options

AssumptionsUnder the new lease accounting rules, a series of assumptions must be made in order to properly account for leases. The assumption with the largest impact on lease obligation value will usually be the likelihood of renewing, canceling, contracting and/or expanding leases based on a contractual or legal right. These assumptions will become extremely important. Take, for example, a two year lease with an option to renew for ten additional years. The value of the lease obligation added to the balance sheet will be roughly six times more if renewal is assumed versus an assumption that the lease will expire in two years. Also, by assuming that the lease will be renewed, the first year P&L lease expense would increase by roughly 20%.

In addition to likely lease term, there are other assumptions that must be made. Assumptions about sales revenue may be necessary for leases that have a contingent rent component. And, assumptions about future market condition will be necessary for leases with options to renew at a rental rate associated to future market conditions.

Assumption-making will not be a one-time event. Assumptions for each lease will have to be revisited and revised periodically. As already noted, these assumptions will be scrutinized by both executive management and auditors. Rigorous processes must be established and followed to prove that lease assumptions are sound.

ProcessesAny processes created or revised to account for leases must comply with provisions of Sarbanes-Oxley Act (SOX). In order to become SOX compliant, processes must be documented and tested prior to implementation within the business. The lease accounting process can be broken down into five sub-processes:

Sub-process #1: Collect and record lease information The goal of this sub-process is to create a complete inventory of leases and verify that all required lease information is accurately recorded for use by other sub-processes.

Sub-process #2: Account for capital and impaired leasesPresent accounting for capital leases and impaired leases that are already on the balance sheet will need to be collated with the lease inventory from sub-process #1 to make sure that these leases are not double-counted.

Sub-process #3: Make necessary lease-assumptions Determining lease assumptions may require the involvement of different groups within the company beyond the real estate and finance groups. For example, business managers may be integral to make sound assumptions about the likelihood of exercising renewal rights for a given lease.

Sub-process #4: Financial projections and calculationsBased on the information and assumptions made available in the previous three sub-processes, the next step in the lease accounting process is to calculate the present value of each lease obligation and create the amortization schedule necessary to account for the lease liability.

Sub-process #5: Make accounting entriesThe final step in the lease accounting process is to enter data into the financial accounting system. Companies will need to invest a significant amount of manpower and talent to design a lease accounting process. Companies will be challenged to design a process that will allow information to move accurately and efficiently from one sub-process to the next.

The effort required to design the process will be large. While some sub-processes might be outsourced, selecting an outsourced provider should be done carefully. Any outsourced provider selected will need internal processes that comply with Sarbanes-Oxley.

TechnologyThe scale of the lease accounting process will be large. Whether for a large company with 1,000 leases or a small enterprise with 10 leases, the lease accounting process is likely to be large relative to the size of the company. Automating specific steps and tasks will be necessary to improve accuracy and productivity. New or enhanced software and IT systems will be required. These systems should be scalable to accommodate growth, flexible to accommodate changes, globally accessible for data entry and access, and integrated with the company’s financial accounting system.

The resources of the IT department will be called upon to help select and implement systems. The required IT resources might be substantial, especially in the early design phases of the process.


The leadership challengeComplying with the new lease accounting standard will require a concerted effort spanning the organizational boundaries of the real estate, finance, accounting, IT and business managers. Leaders within these functions are needed to take on the lease accounting challenge together.

“Seat at the table”Those involved in corporate real estate often talk about gaining a “seat at the table” with key decision makers within the company. The new lease accounting standard will open the door to talk strategy with the CEO, cost structure with the CFO, budgets with business leaders and SOX-compliance with the controller.

All those involved in corporate real estate, from financial analysts to the top real estate executives, will find themselves much more visible, much more respected and much more valued. Of course, with increased visibility comes increased performance scrutiny. But, for many the rewards will outweigh the risks.

Part 5: What You Should Do NextYour First StepsThere are a number of things that companies should do in the near term to prepare for the new lease accounting standard.

Assign point peopleEach function heavily involved in managing or accounting for leases should assign a point person to lead the company’s response to the new accounting rules. The point person from each group should work collaboratively to create a work program and timeline to address the various implications of the new lease accounting standard.

Assess inventory of leasesCompanies should assess the completeness of their lease inventory. The real estate group should work with business units and other functions to identify missing leases and add them to the inventory. Identify information gapsCompanies should review the structure of information in the lease databases and gauge to whether more date points are needed to in order to comply with the new lease accounting standard.

Identify process gapsIn order to determine what additional processes are needed and what processes are likely to be most difficult, companies should review existing processes used to: record lease information, prepare real estate plans, and make accounting entries for leases.

Figure 7: View of overall process

Overall process required to comply with standard


Create decision-making toolsCompanies should create decision-making tools to help evaluate decisions such as lease-vs.-own and lease length. As mentioned earlier, leases signed prior to the Effective Date will probably not be grandfathered and will be added to the balance sheet once the new lease accounting standard is implemented.

Already urgentWhile the new lease accounting standard is not yet finalized, companies should prepare for the new rules now. There are two reasons why early preparation is important. First, companies should already be evaluating real estate decisions through the lens of the new lease accounting standard. There will likely be no grandfathering of leases signed prior to the Effective Date.

Second, companies will need significant time to implement the processes, systems and workforce required to comply with the new standard. Companies will need to design and test processes; integrate new technology into existing systems; and hire and train people. Resources need to be budgeted and procured now. Competition for resources will only become more competitive as the Effective Date of the new accounting standard grows closer.

Managing the implications of the new lease accounting standard will create a significant challenge and companies will require time to understand, evaluate and resolve issues with the new rules. Companies that begin to prepare for the new lease accounting standard today will be well prepared to address the inevitable issues that the new lease accounting standard will present.

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