Perspectives on lease accounting

September 2010

What to make of new lease accounting rules
A long-anticipated draft of proposed lease accounting changes that will put all leases on balance sheet was released on August 16, 2010 by the U.S. Financial Accounting Standards Board (FASB) and its counterpart, the International Accounting Standards Board (IASB). By now, most corporate real estate executives are aware of the new paradigm for lease accounting and its impact on the balance sheet. The reality of the proposal is now shifting the focus to potential changes in leasing strategy and practices as well as meeting requirements for future administration of leases. The Exposure Draft is the latest step in a long-running process to require capitalization of all real estate and equipment leases on balance sheets by recognizing the rights and obligations of lessees. Although a 120-day period of public comment follows the release of the Exposure Draft, the primary elements of the new rule are unlikely to change. A final standard is expected to be issued mid-2011 with an effective date yet to be determined but likely to be no sooner than January 1, 2013. Timeline of events
Exposure draft August 17, 2010 Comments due December 15, 2010 Final standard issued mid-2011

The pressure to revamp the three-decade-old leasing standard is driven by the perceived lack of transparency around off-balance sheet obligations and the complexity of current lease accounting. Today, enterprises choose between two methods for classifying leases—as operating or capital leases. Under the new approach, organizations will recognize a liability for obligations to pay rent and a corresponding asset representing the right to use the underlying leased property. Placing the full lease obligation on the balance sheet and the resulting negative drag on corporate earnings will have a dramatic impact on companies’ perceived financial performance. Changes in the financial reporting process will be daunting and cumbersome as companies must capture new data points and capitalize obligations based on internal evaluation of occupancy practices and use of property.

2010

2011

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2013

Target effective date of new standards

How will companies respond? A major open question is how dramatically companies will react and how significantly they will alter the use of leases and desired lease terms. A knee-jerk response may be for companies to seek shorter term leases or favor ownership if property use goes on the balance sheet anyway. Certainly, the changes will push companies to articulate and validate the reasons for leasing such as flexibility in occupancy and preservation of capital for core business activities. Given the “principles-based” approach to the new leasing standard, certain transactions such as sale-leasebacks and build-to-suit arrangements could be easier to execute. Importantly, they may be achieved with better economic terms for tenants and more suited to their true business objectives. While the standard setters’ concerns about financial engineering of leases frame much of the new approach, these transactions may better align with corporate goals. The new standard will disproportionately affect certain business sectors with a heavy reliance on real estate to generate revenue. Obvious industry candidates are retail but also commercial banking with substantial customer service operations. Retailers operating on notoriously thin margins will witness a substantial erosion of net margin. For retailers, the reported increase in occupancy expense will be exacerbated by a potential tendency to capitalize renewal periods and recognize higher rents under percentage sale arrangements. Although the transition date is not yet specified, the sweeping changes in financial reporting for leases will prompt companies to begin planning for system modifications immediately. The immediate demands will be to: • Assess the suitability of existing lease administration and reporting systems to accommodate the new accounting requirements Plan for enhancement of lease abstracts and processes for additional data capture for existing leases Create standards for assessment of obligations for lease term, net lease expenses and contingent rent that will survive audit review

What’s changing?
• • The distinction between operating leases and capital leases will be eliminated All leases, including existing arrangements, will go on balance sheet and rent will no longer be an operating expense Capitalization of leases based upon the present value of estimated net lease payments over the expected lease term, discounted at the lessee’s incremental borrowing rate Capitalized value will include base rent, net of operating expenses, for the longest term of lease that is more likely than not to occur, with consideration of renewal periods and termination rights, and the expected value of contingent rent and other payment amounts over the same period Continuous reconsideration of estimates used in capitalizing lease liabilities All existing leases will be capitalized based on the remaining lease payments

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What’s the impact?
• • Balance sheets will swell and selected companies will see their debt loads increase by a multiple of 7 to 10 times Total occupancy expense will be higher and front-loaded over the first half of the lease, often 15-20 percent higher than today’s straight-line rent (see comparison of rent expense on page 3) Re-amortization of asset and finance expenses from remeasurement, albeit at the original discount rate, will potentially result in a continuously front-loaded expense profile Organizations must contend with potential violation of financial covenants Reported capital spending will be higher Sectors such as regulated financial services and government contractors will be negatively impacted Financial reporting will become more complex and cumbersome with added burden of continuous reevaluation of assumptions Reported cash flow (EBITDA) will be greater Occupancy expense allocations to business units could change

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Sale-leasebacks The Exposure Draft offers immediate gain recognition for any properties deemed to have been sold under a sale-leaseback arrangement. However, the proposal incorporates many of the

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Corporate real estate directors have become increasingly aware of the proposed changes and impact in the past year. When Jones Lang LaSalle and CoreNet Global surveyed the latter’s U.S. members in 2009, many corporate real estate executives were hearing about the lease accounting change for the first time, and many more were only vaguely aware of its impact.

There are still major topics with a significant impact on corporate real estate yet to be addressed before issuance of the Exposure Draft in the second quarter 2010. In addition to the effective date for the new standard, these topics include treatment of: • Subleases

Comparison of rent expense Figure 2: Comparison of rent expense
$1,900,000 $1,800,000 $1,700,000
Expense

$1,600,000 $1,500,000 $1,400,000 $1,300,000 $1,200,000 $1,100,000 $1,000,000 1 2
FAS 13 Rent

• Sale-leasebacks play a key role in this process. In 2005, the Securities and • Build-to-suit arrangements Exchange Commission estimated that U.S. public companies had a capitalized equivalent of $1.3 trillion in operating leases, translating to approximately $1 trillion in real estate obligations that will need to be capitalized. TOOLS FOR CHANGE

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Years

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Cash Rent

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Right of Use Expense

As the reality of the new standard approaches, many CRE To help clients navigate these straits, Jones Lang LaSalle directors have been proactive in alerting finance executives at has developed a ”calculator” to assess the financial impact their companies aboutleases and different their likely impact. In from capitalization of the changes and lease structures. By using the lease capitalization calculator, corporate real estate recent months, more and more companies are starting to address executives challenge of preparing their existing lease portfolio the dauntingcan: and reassessing the process for structuring effective leases going • Calculate capitalized amounts of leased assets and forward. This reassessment has four essential components: liabilities to go on balance sheet 1. 2. 3.
• Generate new annual expense profile and compare Understand and quantify the impact - test how negotiated to current expense lease terms drive the balance sheet and operating expense • Profile improvements to cash flow/EBITDA Communicate with corporate treasurydiscount rate, about • Run sensitivities to assumptions in and accounting contingent rents and lease term the changes, decisions and reporting needs for the future • Support decision-making in negotiation of lease Anticipate and provisions financial reporting – identify terms and plan for new additional data acquisition and make changes to lease • Provide a baseline for potential peer analysis administration systems

current limitations on from the new standard will be significant and The expected effects continuing involvement of the seller under U.S. GAAP (which are more subjectively evaluated today under IFRS). include: These limitations include features such as purchase options other than at fair value, seller financing and shared appreciation. Any • Substantially larger balance sheets from reporting leased leaseback terms that are obligations such as rent, will require an assets and lease not at market, adjustment to the recognized sale value and gain. • Higher reported initial occupancy expenses, as much as Subleases percent, as straight-line rent expense is replaced by 20 Whenever a tenant subleases its space, an additional asset must be recognized for the rent receivable and a liability for the sub-landlord’s “performance obligation.” This will require the tenant / sublandlord to make similar decisions around its subtenant’s occupancy as it made on its own occupancy. In addition to the primary right of use asset and liability, sublease amounts will need to be recognized but will be presented on a net basis. Build-to-suit leases Development arrangements are not addressed in the Exposure Draft since they relate to the pre-lease period and are not, therefore, part of lease accounting. However, all leases will need to be recognized when they are executed even though the lease has not yet commenced. Additional complexity in applying the standard will arise from situations such as statutory leasing provisions, rent reviews, impact on regulated industries, lease modifications, impairment and deferred tax assets. Corporate Real Estate’s Role Because property leases represent roughly 70 percent of all operating leases, corporate real estate (CRE) directors

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Re-assess negotiated lease terms and principles for lease vs. own decision-making

Sweeping changes in lease accounting will give CRE executives a valuable opportunity to support the fundamental business reasons for leasing and to clarify when financial reporting objectives are merely a subsidiary issue. Placing the focus on valued operating flexibility and preservation of capital for core business investment will help organizations navigate through the undoubtedly challenging time ahead with new lease accounting. For more information, please contact: Mindy Berman Managing Director, Capital Markets +1 617 316 6539 mindy.berman@am.jll.com Vivian Mumaw Director, Global Lease Administration +1 312 228 2878 vivian.mumaw@am.jll.com www.us.joneslanglasalle.com

© 2010 Jones Lang LaSalle IP, Inc. All rights reserved. No part of this publication may be reproduced by any means, whether graphically, electronically, mechanically or otherwise howsoever, including without limitation photocopying and recording on magnetic tape, or included in any information store and/or retrieval system without prior written permission of Jones Lang LaSalle IP, Inc. All information contained herein is from sources deemed reliable; however, no representation or warranty is made to the accuracy thereof. Jones Lang LaSalle Brokerage, Inc., California license # 01856260. Jones Lang LaSalle Americas, Inc., California license # 01223413.

© 2010 Jones Lang LaSalle IP, Inc. All rights reserved. No part of this publication may be reproduced by any means, whether graphically, electronically, mechanically or otherwise howsoever, including without limitation photocopying and recording on magnetic tape, or included in any information store and/or retrieval system without prior written permission of Jones Lang LaSalle IP, Inc. All information contained herein is from sources deemed reliable; however, no representation or warranty is made to the accuracy thereof. Jones Lang LaSalle Brokerage, Inc., California license # 01856260. Jones Lang LaSalle Americas, Inc., California license # 01223413.