FASB/IASB LEASE ACCOUNTING IMPACT PREPARED BY: DAN DOKOVIC ddokovic@intelicacre.com 15455 CONWAY ROAD ST. LOUIS, MO 63017 314.270.5991 INTELICACRE.COM
2012 Intelica CRE. All Rights Reserved. No part of this publication may be reproduced in any form electronically, by xerography, microfilm, or otherwise, or incorporated into any database or information retrieval system, without the written permission of the copyright owners. FASB/IASB Lease Accounting Impact is published by: Intelica CRE 15455 Conway Road, Suite 100 Chesterfield, MO 63017 Intelica CRE is a St Louis based nationally operating company specializing in commercial real estate services including tenant representation, project leasing and sales, property management, corporate services, capital markets, development services, and research. By building on our strong foundation of intellectual capital, Intelica delivers value to owners, investors and users of commercial real estate. Intelica manages and leases space in nine national markets comprising of more than 4 million square feet valued at approximately $450 million. Please visit INTELICACRE.COM for more information about our company. Disclaimer: This report is designed to provide general information in regard to the subject matter covered. This report does not constitute an offer to sell or a solicitation of an offer to buy any services, and the authors of this report advise that no statement in this report is to be construed as a recommendation to make any real estate investment or to buy or sell any security or as investment advice. Neither Intelica CRE, nor any of their respective directors, officers, and employees warrant as to the accuracy of or assume any liability for the information contained herein. 2
TABLE OF CONTENTS INTRODUCTION 4 LEASE ACCOUNTING OUTLINED 5 LEASE ACCOUNTING IMPACT 6 CONCLUSION 8 3
INTRODUCTION On August, 17, 2010 the Financial Accounting Standards Board (FASB) released their exposure draft requiring companies to record nearly all leases on their balance sheets as right to use assets, and a corresponding future lease payment - liability. According to FASB, the effort is an initiative to standardize the U.S. lease accounting practices according to global accounting standards and to more accurately provide users of financial statements with a complete and understandable picture of an entity s leasing activities as well as more accurate financial picture. The Accounting Boards are trying to eliminate a form over substance distinction in GAAP accounting regarding typical, non-financing operating leases that has supposedly led to confusion and potential under-reporting in financial statements. The Boards consider all leases, including operating leases, to be financially equivalent to purchasing the right to use an asset and financing it. On this subject, Sir David Tweedie has been famously quoted that One of my great ambitions before I die is to fly in an aircraft that is on an airline s balance sheet. 2010 2011 2012 2013 2014 2015 2016 BEYOND Convergence Exposure drafts Final standards Effective * IFRS timeline - condorsement Category 1 Category 2 & 3 (e.g., 5-7 years) IFRS timeline - conversion SEC decision? IFRS opening B/S Parallel reporting - comparative IFRS only The middle line of the graph above contains a new word specifically created by the SEC to describe the bridge being constructed between convergence and endorsement. While the proposal has gone through two rounds of exposure drafts, the final staff paper due in May most likely outlines the United States endorsement of the program over the next five to seven years. As the below chart shows and assuming the three year conversion period, the standards could be effective as early as 2015. While there are a lot of moving parts including the SEC s decision on how to proceed with the entire condorsement of the IFSR standards and U.S. GAAP, U.S. and global accounting standards continue their march toward convergence. 4
LEASE ACCOUNTING OUTLINED What does this mean? The FASB proposal does away with operating leases; all leases (unless immaterial) would be capitalized using the present value of the minimum lease payments. Off-balance sheet financing though operating leases will be eliminated and all leases will be recorded on the balance sheet. In the process of conversion, all existing leases will also be affected by the proposed standard no existing leases will be grandfathered. All leases signed prior to the implementation of the new rules, will require reclassification as capital leases that must be accounted for on the balance sheet. As a part of the proposal, companies will have to estimate lease term and payments (renewals, contingent rents, residual guarantee payments) and capitalize at incremental borrowing rate with continual adjustments to estimate. A proposed lessee model will result in higher interest expense in earlier years therefore accelerating recognition of all lease costs. Lessee will initially measure and recognize asset and liability at the present value of the expected lease payments to be made over the lease term. Thereafter lease payments will be allocated as a reduction of the liability. Illustrated below is an effect of the proposed accounting standard on the company s lease accounting. Lease with annual payments (see current lease expense) Present Value of lease payments: 3 years YEAR 0 YEAR 1 YEAR 2 YEAR 3 Current Lease Expense $6,000.00 $6,000.00 $6,000.00 New Accounting Standard Interest Expense $1,500.00 $900.00 $600.00 Depreciation $5,000.00 $5,000.00 $5,000.00 Total Lease Expense $6,500.00 $5,900.00 $5,600.00 Balance Sheet Right of Use Asset (RUA) $15,000.00 $10,000.00 $5,000.00 $ --- Lease Liability $15,000.00 $10,500.00 $5,400.00 $ --- *numbers rounded for presentation purposes 5
LEASE ACCOUNTING IMPACT What does this mean to business? Lease accounting changes will have a vast impact on the businesses. Some of these effects include: Financial Statement impacts (Income Statement, Balance Sheet, Cash Flow, Capital Requirements, and Financial Ratios), Changes in Leasing vs. Ownership considerations, Change in lessee/lessor structuring motivations, and burdensome compliance and administrative impact. Below addressed are some of these effects. A company s Income Statement will change and reported net income could be depressed in the early years of a lease. Straight-line rent expense will be replaced with interest expense plus the amortization of the right-of-use asset. Because the interest expense will be higher in the earlier years, the total annual occupancy expenses will be front-loaded. The impact of recording these lease obligations on the balance sheet can have multiple impacts, such as: businesses needing to alert their lenders as they may now be non-compliant with loan covenants, negotiate new loan covenants with lenders due to restated financial statements, ratios used to evaluate a business s potential of credit may be adversely impacted, the restatement of a lessee s financial statement may result in a lower equity balance, as illustrated below. FINANCIAL RATIO IMPACT FOR LESSEES Ratio Liquidity Ratios Current Ratio (Based on Current Portion of Lease Liability) Leverage Rates Debt to Equity Ratio (Total Debt increases; Total Equity decreases) Debt Ratio (Assets & Liabilities increase by same amount) (Assuming Total Debt<Total Assets) Times Interest Earned Ratio (EBIT decreases; interest expense increases) Efficiency Ratios Asset Turnover (Increase in Total Assets; no change in net sales) Profitability Ratios ROA ( in NI; increase in Total Assets ROE (Assumes equal decrease in NI & Equity) Profit Margin ( in NI; no change in net sales Expected Change under Proposed Model Increase Increase 6
LEASE ACCOUNTING IMPACT Many businesses that were traditionally Lessees in the market will consider owning as the benefits of leasing will change. Businesses that decide to continue with leasing will opt for shorter leases that will not have as great of a front loaded impact on their financial statements. Leases could become more complex as Lessors and Lessees objectives diverge. Tenants will be incentivized to sign relatively short-term leases creating problems for landlords, lenders and investors. 7
CONCLUSION While we are still a long way from the final changes to the lease accounting standards, and an even longer way before the new standards must be implemented, businesses need to familiarize themselves with the project details. It would be prudent for all businesses with significant lease obligations to review their lease documents as they would be reflected in the new standards. It would be more important now than ever to review your lease administration practices and include some of the terms that might impact your financials in the future such as estimated terms and lease contingent rents. Additionally, a quick review of the possible right of use liabilities can be calculated to better prepare for the future changes and adjust your leases accordingly. If you would like to discuss the impact of FASB/IASB account on your company s leases, please contact your usual Intelica CRE advisor or any of the contacts listed below: Dan Dokovic Chief Operating Officer 314.603.0996 ddokovic@intelicacre.com Gary Parker Chief Executive Officer 314.503.0751 gparker@intelicacre.com Dan Merlo President 314.409.1624 dmerlo@intelicacre.com Kent Evans Vice President Brokerage 314.420.8696 kevans@intelicacre.com 8