© Grant Thornton. All rights reserved. The Changing Landscape of Lease Accounting A joint IASB/FASB project Alvin Wade Audit Partner May 26, 2011.

© Grant Thornton. All rights reserved.

The Changing Landscape of Lease AccountingA joint IASB/FASB project

Alvin WadeAudit Partner

May 26, 2011


What is the catalyst behind the proposed changes?

• The Sarbanes-Oxley Act required the SEC to do a study of off-balance sheet transactions.

• Lessee off-balance sheet operating leases were cited as a major financial reporting deficiency.

• The FASB and the International Accounting Standards Board (IASB) have formed a joint project to converge world-wide accounting rules (including lease accounting).


What is the primary objective of the proposed changes?

• To require all leases to be recognized on the balance sheet of lessees and lessors


Originally proposed impact on the lessee

• Required to record an asset representing the right to use the asset over the lease term

• Record a liability for the obligation to pay rentals

• The recorded asset and liability require the lessee to estimate certain future events and conditions such as renewal options, contingent rents and incremental borrowing rate


Types of arrangements scoped out include:

• Leases of intangible assets

• Leases to explore for or use natural resources

• Leases of biological assets

• Contracts that represent the purchase or sale of the underlying asset


• Based on nearly 800 comment letters – the boards re-deliberated the following:– Lease term– Variable lease payments– Income and expense recognition pattern– Lease definition

Changes to proposed ED


Definition of lease term

• Originally proposed– The longest possible lease term that is more

likely than not to occur (greater than 50%)

• Currently proposed– The non-cancellable period, plus any options

where there is a significant economic incentive to extend


Economic incentives

• Cancellation penalties for non-renewals• Bargain purchase price• Significant installation costs (i.e. customized tenant

improvements)


Variable lease payments (contingent rents, termination penalties)

• Originally proposed– Amounts were to be estimated under various

scenarios and included as part of your assets and liabilities recognized

• Currently proposed– Higher recognition threshold established to

include certain performance based contingent rents in definition of lease payments


Income and expense recognition pattern

• Originally proposed– Front end loaded expense and income

recognition

• Currently proposed– No change – consideration was being given to

allowing straight line recognition of lease income and expense for leases not having a significant financing element.


Comparison of current treatment to the proposed standard

A simple example:

• Lease Term - 5 years, annual rent is $20,000 per year

• Lessee's incremental borrowing rate = 8%


Comparison of current treatment to the proposed standard (continued)

A simple example:

Current Treatment

Proposed New Standard Difference

Year Lease Expense

Depreciation Interest Total

1 $20,000 $14,706 $7,550 $22,256 $(2,256)

2 20,000 14,706 6,520 21,226 (1,226)

3 20,000 14,706 5,400 20,106 (106)

4 20,000 14,706 4,200 18,906 1,094

5 20,000 14,706 2,800 17,506 2,494

Total $100,000 $73,530 $26,470 $100,000 $0


Comparison of current treatment to the proposed standard (continued)

• Front ends lease expense as straight-line depreciation and imputed interest replace straight line rent.


Proposed standard requires estimate of lease term and payments

• Renewal options

• Contingent rents

• Incremental borrowing rate


Renewal options/contingent rents

Base term (years 1-5) $20,000 + 2% of sales

First renewal (years 6-10) $25,000 + 2% of sales

Second renewal (years 11-15) $30,000 + 2% of sales

IBR-8%


Assume:-Will exercise only first renewal-Contingent rents = $500 year 1 and grow $20/year

Current Treatment

Proposed New Standard Difference

Year Depreciation Interest Total

1 $23,000 $15,091 $12,394 $27,485 $(4,485)

2 23,020 15,091 11,721 26,812 (3,792)

3 23,040 15,091 10,990 26,081 (3,041)

4 23,060 15,091 10,196 25,287 (2,227)

5 23,080 15,091 9,335 24,426 (1,346)

6 23,100 15,091 8,214 23,305 (205)

7 23,120 15,091 6,769 21,860 1,260

8 23,140 15,091 5,201 20,292 2,848

9 23,160 15,091 3,505 18,596 4,564

10 23,180 15,091 1,665 16,756 6,424

Total$230,900 $150,910 $79,990

$230,900

$0


Business implications of proposed model

• Impact on loan covenants and financial ratios– debt to equity ratios– interest coverage

• Impact on buy vs. lease decisions

• Impact on standard lease terms (may want shorter leases)

• Tenants may want to renegotiate existing long-term leases


Impact on landlord (lessor)

• Required to recognize leases on their balance sheet

• Desire symmetry between lessor and lessee

• Several approaches being considered– Performance obligation approach

– Derecognition approach

– Hybrid model


Performance obligation

• Lessor records lease receivable based on estimated lease term and contingent rents received

• Payments discounted using implicit interest rate in the lease

• Interest income recognized on the effective interest method

• Liability recorded for obligation to provide the use of the space and amortized over life of the lease



A simple example:

• Lease Term - 5 years, annual rent is $20,000 per year

• Implicit interest rate = 8%



A simple example:Current

TreatmentProposed New Standard Difference

Year Lease Income

Rental Income

Interest Income

Total

1 $20,000 $14,706 $7,550 $22,256 $(2,256)

2 20,000 14,706 6,520 21,226 (1,226)

3 20,000 14,706 5,400 20,106 (106)

4 20,000 14,706 4,200 18,906 1,094

5 20,000 14,706 2,800 17,506 2,494

Total $100,000 $73,530 $26,470 $100,000 $0


Derecognition model

• Lessor would partially derecognize the underlying asset

• Residual interest in investment property and lease receivable will be recorded to the B/S as separate assets


Status of proposed project

• Boards continue to deliberate final revisions to the proposed standard

• Changes needed to lessor accounting will be considered as a separate project or later as part of this project

• Final standard still targeted for 2011


Questions

The New Lease Accounting StandardsThe Real Estate Perspective

http://www.cyberleasellc.com/

Key differences− No More Operating Leases

− Balance Sheet Impact

− FAS 13: Operating Lease – It is off the balance sheet

− FAS 13: Capital Lease – On balance sheet

− New Standard: All leases on balance sheet, and impact for some leases is larger than under FAS 13 Capital Lease.

− Renewal Options – If “significant economic incentive”− Contingent Rents – If “disguised” − “Short term” leases not capitalized (but active debate at

May meeting)

The New Standards (as of April 21, 2011)

A Brief Overview

Key differences− Income Statement Impact

− FAS 13: Operating Lease – Straight line rent over term

− FAS 13: Capital Lease – Amortization of asset (PV of rent at lessee’s incremental borrowing rate) + Interest expense on remaining liability.

− New Standard:

− Boards Must Like The Texas Two-Step …

− To know what’s happening you need a calendar

The New Standards (as of May 20, 2011)

A Brief Overview

Key differences− Income Statement Impact

− August 2010:Exposure Draft –

All leases the same Amortization + Interest; Front Loaded P&L

profile

− April 2011:Revised Proposal Approved by Boards: 2 kinds of leases:

“Finance Lease” – ED Method“Other Than Finance Lease” – Calculated on straight line with interest component, but presented as “rent expense” on P&L

− May 19, 2011:Boards agree to reverse course – back to ED Method / no classification


A Brief Overview

− Renewal & Termination Options Included In Calculations:− FAS 13: “Reasonably assured” = rarely triggered

− New Standards:− Original Exposure Draft : “More likely than not”

− Revised Proposal: Include if “Reasonably certain” based on the presence of a “significant economic incentive” to renew or terminate

… so much for objective criteria …

− Is 95% of FMV renewal a “clear economic incentive”?− High value T.I.s with remaining life would be though− Critical / strategic business use for space− Easier to trigger for Lab, Manufacturing, SCIF and custom

space

Key differences - Options


A Brief Overview

− Contingent Rents Included In Calculations:− FAS 13: CPI, Yes; Other Contingent Rents, No.

− New Standards:− Original Exposure Draft: All included based upon

probability weighted outcomes (a.k.a. the crystal ball method)

− Revised Proposal: − CPI based on “spot” rate as opposed to probable− Percentage Rent

− Only if “disguised minimum rent”− Based on expected outcome / estimate

Key differences – Contingent Rents

The New Standards (as of April 21, 2011)

A Brief Overview

− Executory Costs:− FAS 13: All are excluded for both capital and operating

− New Standards: − Original Exposure Draft: Executory costs replaced with

“Distinct Service Components”, not same as Executory Costs

− “Distinct service components” not capitalized as asset / liability

− Non-distinct service components – notably property taxes and insurance – to be capitalized

− Revised Proposal:− Separate “lease” and “non-lease” components− Not via Rev. Rec. / “Distinct Service Components”− “Observable prices”

Key differences – Executory Costs


A Brief Overview

Combo of Front Loaded P&L + Executory / Non-Lease

• Revised proposals make current and future executory treatment the same

• Effect on tenants with gross leases• Most have not removed base expenses from FAS 13 rent• Constant base amounts and straight line rent have same P&L. • Not the case with new standards due to front loading.

• Impact: More work / calculations to avoid overstating asset and liability.

• Creates added incentive for tenant to ensure base year costs are as high as possible because:

−Reduces add’l rent expense, −Keeps more $ off balance sheet

New Lease Accounting RulesExecutory / Non-Lease Components

Specific Issues To AddressDetermining the Term: “Significant Economic Incentives”

The Case of One Lease

•Key Assumptions For Exercise:

− 100,000 RSF

− Tenant’s Incremental Borrowing Rate – 7.0%

− 10 Year Term, with one 10 Year Renewal Option

− Rental Payments / Year / RSF

−Include taxes + insurance, exclude “Distinct Service Components”

−Annual Rent

− Years 1 – 3: $40 / RSF

− Years 4 – 6: $45 / RSF

− Years 7 – 10: $50 / RSF

− Renewal: FMV but not less than $50 / RSF

New Lease Accounting RulesImpact of Renewal / Termination Options

Renewal Options

•Determining “significant economic incentive”.

•Are renewal options truly exercised in most cases?

•To what extent will income statement sensitivity drive renewal decisions?

•Need auditable process / mechanism by which renewal “decisions” can be tested.

•Second guessing of renewal determination by competing interests

•A few “what if?” examples:


10 Year Term Without Renewal Income Statement Impact By Year

$-

$1,000,000

$2,000,000

$3,000,000

$4,000,000

$5,000,000

$6,000,000

1 2 3 4 5 6 7 8 9 10

Years

Amor

t & In

t Exp

1st 10 Yr Term - No Renew

Baseline Scenarios #1: No Signficant Economic Incentive


Renewal Likely At Lease Commencement Date ("LCD") Income Statement Impact By Year

$-

$1,000,000.00

$2,000,000.00

$3,000,000.00

$4,000,000.00

$5,000,000.00

$6,000,000.00

$7,000,000.00

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Years

Renew Likely @ LCD

Baseline Scenario #2: “Significant Economic Incentive” Exists


Two Separate 10 Year Terms: Non-Renewal Income Statement Impact By Year

$-

$1,000,000

$2,000,000

$3,000,000

$4,000,000

$5,000,000

$6,000,000

$7,000,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Years

Amor

t & In

t Exp

1st 10 Yr Term - No Renew

2nd 10 Yr Term

Baseline Scenario #3: No “Significant Economic Incentive”, Lease Renewed


… No Incentive At LCD, But At End of Year 5 Incentive Materializes?

Real World ConsequencesForget Baseline: What Happens When …

Impact on Income Statement From Revised Renewal Decision: Now Likely to Renew

$-

$1,000,000.00

$2,000,000.00

$3,000,000.00

$4,000,000.00

$5,000,000.00

$6,000,000.00

$7,000,000.00

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Years

Single 10 Yr No Renewal

Renew Likely @ Yr 6

Real World ConsequencesForget Baseline: What Happens When …?

Impact of Decision: Immediate Losses, Aggregate “Wash”, NPV is Loss

Income Statement / Profit Impact From Revised Renewal Decision

$(2,500,000.00)

$(2,000,000.00)

$(1,500,000.00)

$(1,000,000.00)

$(500,000.00)

$-

$500,000.00

$1,000,000.00

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Years

Profit Impact 10 Yr NoRenew vs Renew @ Yr 6

Profit Impact Renew @ Yr6 vs New 10 Yr Term

Impact On Lease Negotiations – Death of “Blend & Extend” Deals?

New Lease Accounting RulesExample Of Unintended Consequences

Transitioning To New StandardHow, When & Who

New Lease Accounting RulesTransitioning Existing Leases: Sample Calcs

NPVClient GD-AIS OpEx Date Tax Date Ins. Date TI Allowance / RSF 2.23$ Free Parking Annual NPVProperty Description Santa Clara of Payment 9/1/2005 of Payment 9/1/2005 of Payment 9/1/2005 Net TI Cost/RSF -$ /Average RSF ($)Intial Square Footage 358,503 8.15$ Lease Commencement Date 5/20/2005 Annual OpEx Annual Tax Annual Ins. Tenant pays contracts EFFECTIVERent Commencement Date 5/20/2006 Increase 3.00% Increase 2.00% Increase 3.00% for utilities directly RATELease Expiration Date 5/19/2016 Asset Beg, Bal. 14,007,441.69$ Annual NetRenewal Option Commence Date N/A First Year First Year First Year Liability Beg. Bal. 14,007,441.69$ Effective RateLease Structure NNN Expense 0.11$ Expense 0.78$ Expense 0.01$ 11.01$

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016Gross Base Rent ($) -$ 2,542,364.50$ 4,167,472.09$ 4,230,624.52$ 4,295,155.06$ 4,359,685.60$ 4,424,216.14$ 4,490,953.59$ 4,559,069.16$ 4,627,184.73$ 4,695,300.30$ 1,814,979.26$ Operating Expenses ($) 13,232.35$ 40,887.95$ 42,114.59$ 43,378.02$ 44,679.37$ 46,019.75$ 47,400.34$ 48,822.35$ 50,287.02$ 51,795.63$ 53,349.50$ 21,123.25$ Taxes ($) 92,906.05$ 281,505.34$ 287,135.45$ 292,878.15$ 298,735.72$ 304,710.43$ 310,804.64$ 317,020.73$ 323,361.15$ 329,828.37$ 336,424.94$ 130,605.08$ Insurance ($) 605.87$ 1,872.14$ 1,928.30$ 1,986.15$ 2,045.74$ 2,107.11$ 2,170.32$ 2,235.43$ 2,302.49$ 2,371.57$ 2,442.72$ 967.17$ Tenant Improvements ($) -$ -$ -$ -$ -$ -$ -$ -$ -$ -$ -$ -$ Total ($) 106,744.27$ 2,866,629.93$ 4,498,650.43$ 4,568,866.85$ 4,640,615.87$ 4,712,522.88$ 4,784,591.44$ 4,859,032.10$ 4,935,019.82$ 5,011,180.30$ 5,087,517.45$ 1,967,674.76$ Total ($ / RSF) 0.30$ 8.00$ 12.55$ 12.74$ 12.94$ 13.15$ 13.35$ 13.55$ 13.77$ 13.98$ 14.19$ 5.49$

Asset (At Year End) ($) -$ -$ -$ -$ -$ -$ -$ -$ $9,868,626.51 $5,729,811.34 $1,590,996.16 $0.00Liability (At Year End) ($) -$ -$ -$ -$ -$ -$ -$ -$ $10,225,289.25 $6,186,489.46 $1,785,380.52 ($0.00)

Rent Expense ($) 2,429,179.89$ 3,946,091.36$ 3,946,091.36$ 3,946,091.36$ 3,946,091.36$ 3,946,091.36$ 3,946,091.36$ 3,946,091.36$ -$ -$ -$ -$ Selling, General & Admin ($) 106,744.27$ 324,265.43$ 331,178.34$ 338,242.33$ 345,460.82$ 352,837.29$ 360,375.30$ 368,078.51$ 375,950.66$ 383,995.57$ 392,217.15$ 152,695.50$ Amortization ($) -$ -$ -$ -$ -$ -$ -$ -$ 4,138,815.18$ 4,138,815.18$ 4,138,815.18$ 1,590,996.16$ Interest ($) -$ -$ -$ -$ -$ -$ -$ -$ 836,564.23$ 564,825.28$ 268,518.22$ 19,184.02$ Total 2,535,924.16$ 4,270,356.78$ 4,277,269.69$ 4,284,333.69$ 4,291,552.18$ 4,298,928.64$ 4,306,466.66$ 4,314,169.87$ 5,351,330.07$ 5,087,636.03$ 4,799,550.55$ 1,762,875.68$

ANNUAL CASH FLOWS

BALANCE SHEET (YEAR)

PROFIT & LOSS IMPACT (YEAR)

CYBERLEASE, LLC - LASER® LEASE ACCOUNTING REPORT

ASSET & LIABILITYAT EFFECTIVE DATE

PARKING, PERCENTAGE RENT AND OTHERBASIC ASSUMPTIONS OPERATING EXPENSES TAXES INSURANCE TI AND UTILITIES

New Lease Accounting RulesTransitioning Existing Leases: Sample CalcsP&L – FAS 13 vs. New Standard

New Lease Accounting RulesTransitioning Existing Leases: Sample CalcsCash Flows Remain The Same

New Lease Accounting RulesTransitioning Existing Leases: Sample CalcsBalance Sheet Impact

Implementation ChallengesTransition vs. New Deals vs. Monitoring

AN AUDITABLE PROCESS IS REQUIRED

•Sarbanes Oxley – who will sign off on subjective decision?

•Consistent practice across company’s lease portfolio

•Subjective nature of decisions needs objective support• Term – Renewal and Termination Options• Contingent Rents • Incremental borrowing rate• Initial direct costs• Non-Lease Components / Observable Costs

•Process / calculations / decisions revisited as circumstances change.

•Outside assistance / resources

Implementation ChallengesTransition vs. New Deals vs. Monitoring

•Its sooner than most realize

•Lead time to gather necessary information and documents

•Lead time to institute corporate process / standardization

•Dual Standards between now and Effective Date

•Multiple stakeholders

•Legal, risk and compliance issues

•ERP Financial reporting systems

Implementation ChallengesTransition Planning

•“Date of Initial Application” (DIA)

• Effective Date is “transition” date, but need to report based on new standard sooner, based upon comparative financial statement requirements of lessee

•Determining Your DIA

• If Effective Date is 1/1/15 companies providing comparative financial statements:

• 5 years = DIA of 2011 • 4 years = DIA of 2012• 3 years = DIA of 2013

•Which leases to include

• All leases in effect on the first day of the lessee’s DIA

• All leases executed between DIA and Effective Date


•Dual Standards

• Between today and Effective Date, report based on FAS13

• Between Date of Initial Application & Effective Date, • Report based on FAS 13• Track based on New Standards

• Systems and reporting must therefore track both standards

•Asset & Liability

• At DIA / Effective Date the Asset & Liability equal the PV of then-remaining lease payments

• At DIA / Effective Date the Asset & Liability are calculated using the tenant’s then-current “Incremental Borrowing Rate”

• Yes, this means separate calculations each year between DIA and Effective Date!


•Team Members

• Direct Involvement:

• Corporate Real Estate Leaders

• Business Unit Real Estate Team

• Corporate Finance (CFO, Treasury, Controller)

• Business Unit Finance

• 3rd Party Expert Advisors & Audit

• Legal

• Governance, Risk & Compliance

• Indirect Involvement:

• Brokerage Teams

• Project Managers (TI Costs)

• Landlord / Property Managers


Questions?Contact Information

Marc A. Maiona

CyberLease, LLC

18818 Teller AvenueSuite 250Irvine, CA 92612

[email protected]

Phone – 949-798-0540

Web – www.cyberleasellc.com

http://www.cyberleasellc.com/

What La Quinta is doing nowAssessing scope of impactReviewing Timing of implementationUpdating inventory of leases

– Completeness– Some provisions much more relevant

» Variable lease payments» Options and related penalties» Interest rate» Initial direct costs» Residual value guarantees» Transfer of risk & reward (lessor)

54

What La Quinta will need to do soon

Talk to Operations–Assess renewal option probabilities–Obtain input for estimating variable lease payments–Ensure Accounting is “top of mind” for new leases,

amendments, etc.

Consider impact on owners, lenders–EBITDAR?

Consider periods needed for retrospective application

55

© Grant Thornton. All rights reserved. The Changing Landscape of Lease Accounting A joint IASB/FASB project Alvin Wade Audit Partner May 26, 2011.

Documents

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