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 The pressure to revamp the three-decade-old leasing standard is

driven by the perceived lack of transparency around off-balance
Exposure draft
sheet obligations and the complexity of current lease accounting.
August 17, 2010
Today, enterprises choose between two methods for classifying
Comments due
December 15, 2010 leases—as operating or capital leases. Under the new approach,
organizations will recognize a liability for obligations to pay rent and
Final standard issued
a corresponding asset representing the right to use the underlying
mid-2011
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
2010 2011 2012 2013 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
Target effective date of
and use of property.
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
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
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
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 re-
evaluation of assumptions
• Reported cash flow (EBITDA) will be greater
• Occupancy expense allocations to business units
could change
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
Figure of rent expense
2: Comparison of rent expense play• a key
Sale-leasebacks
role in this process. In 2005, the Securities and
$1,900,000
Exchange
• Commission
Build-to-suit estimated that U.S. public companies
arrangements
$1,800,000
had a capitalized equivalent of $1.3 trillion in operating leases,
$1,700,000 translating to approximately $1 trillion in real estate obligations
that will need to be capitalized.
$1,600,000 TOOLS FOR CHANGE
Expense

$1,500,000
As the reality of the new standard approaches, many CRE
$1,400,000 To help clients navigate these straits, Jones Lang LaSalle
directors have been proactive in alerting finance executives at
$1,300,000 has developed a ”calculator” to assess the financial impact
their
fromcompanies about
capitalization the changes
of leases and their
and different leaselikely impact.
structures. By In
$1,200,000
recent
using months,
the leasemore and more
capitalization companies
calculator, are starting
corporate to address
real estate
$1,100,000 executives can:
the daunting challenge of preparing their existing lease portfolio
$1,000,000
1 2 3 4 5 6 7 8 9 10 and reassessing the process for structuring effective leases going
Years • Calculate capitalized amounts of leased assets and
forward. This reassessment
liabilities has four
to go on balance essential components:
sheet
FAS 13 Rent Right of Use Expense Cash Rent

• Generateand
1. Understand newquantify
annual the
expense
impactprofile
- testand
howcompare
negotiated
to current expense
lease terms drive the balance sheet and operating expense
current limitations
The expected on from
effects continuing involvement
the new of be
standard will thesignificant
seller under
andU.S. • Profile improvements to cash flow/EBITDA
GAAP
include:(which are more subjectively evaluated today under IFRS). 2. Communicate
• with corporate
Run sensitivities treasury
to assumptions and accounting
in discount rate, about
These limitations include features such as purchase options other the changes,
contingentdecisions
rents andand reporting
lease term needs for the future
than• at fair value, seller
Substantially financing
larger balanceand shared
sheets appreciation.
from Any
reporting leased • Support decision-making in negotiation of lease
3. Anticipate
terms and plan for new financial reporting – identify
and provisions
leaseback termsand
assets thatlease
are obligations
not at market, such as rent, will require an
additional data acquisition and make changes to lease
adjustment to the recognized sale value and gain. • Provide a baseline for potential peer analysis
• Higher reported initial occupancy expenses, as much as administration systems
Subleases 20 percent, as straight-line rent expense is replaced by
Whenever a tenant subleases its space, an additional asset must be 4. Re-assess negotiated lease terms and principles for lease vs.
recognized for the rent receivable and a liability for the sub-landlord’s own decision-making
“performance obligation.” This will require the tenant / sublandlord to Sweeping changes in lease accounting will give CRE executives a
make similar decisions around its subtenant’s occupancy as it made valuable opportunity to support the fundamental business reasons
on its own occupancy. In addition to the primary right of use asset for leasing and to clarify when financial reporting objectives are
and liability, sublease amounts will need to be recognized but will be merely a subsidiary issue. Placing the focus on valued operating
presented on a net basis. flexibility and preservation of capital for core business investment
will help organizations navigate through the undoubtedly
Build-to-suit leases challenging time ahead with new lease accounting.
Development arrangements are not addressed in the Exposure
Draft since they relate to the pre-lease period and are not, therefore, For more information, please contact:
part of lease accounting. However, all leases will need to be
Mindy Berman
recognized when they are executed even though the lease has not Managing Director, Capital Markets
yet commenced. +1 617 316 6539
Additional complexity in applying the standard will arise from situations mindy.berman@am.jll.com
such as statutory leasing provisions, rent reviews, impact on regulated Vivian Mumaw
industries, lease modifications, impairment and deferred tax assets. Director, Global Lease Administration
+1 312 228 2878
Corporate Real Estate’s Role
vivian.mumaw@am.jll.com
Because property leases represent roughly 70 percent of
all operating leases, corporate real estate (CRE) directors 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.