Corporate Real Estate - Lease Accounting

8/17/2019 Corporate Real Estate - Lease Accounting

1/24The overhaul of IFRS lease accounting: Catalyst for change in corporate real estate 1

pwc

The overhaul of IFRS leaseaccounting: Catalyst for change incorporate real estate

July 2010

Asset Management


2/24PricewaterhouseCoopers

Overview of the proposed new lease standard

Proposal will eliminate off-balance sheet accounting; essentially all assets currently leased under operating•leases will be brought on balance sheet

Income statement “geography” and timing of recognition will also change because straight-line rent expense•will be replaced by interest expense (which will be greater in earlier years, like a mortgage) plus straight-lineamortisation of the leased asset, such that total expense will be front-ended

These new assets and liabilities will be recognised and carried at amortised cost, based on the present value of•

payments to be made over the term of the lease

The lease term will include optional renewal periods that are more likely than not expected to be exercised (this•is substantially different than today’s model). Lease payments used to drive the initial value of the asset andliability will now include “contingent” amounts, such as rents based on a percentage of a retailer’s sales and rentincreases linked to, say, to Consumer Price Index (CPI)

Lease renewal and contingent rents will need to be continually re-assessed, and the related estimates trued up•as facts and circumstances change

The proposed lease accounting model will require significant systems and process changes at adoption date•and maintenance on an ongoing basis

Pre-existing leases are not expected to be grandfathered•



The International Accounting StandardsBoard (IASB) and Financial AccountingStandards Board (FASB) (collectively, the“Boards”) are nearing the Exposure Draftstage (expected issuance after mid-2010)on an ambitious joint proposal that wouldradically transform lease accountingfrom the existing model which hasexisted for over 30 years. These changeswould impact almost every companybut are especially relevant to those that

are significant users of real estate. Theproposal suggests a completely newmodel for lessee accounting under whichlessee’s rights and obligations underall leases, existing and new, would becapitalised on the balance sheet.

In March 2009, the Boards issued a

discussion paper: “Leases: Preliminary Views.” The paper described a right-

of-use model for lessee accounting.

Using the feedback received in more

than 300 comment letters, the Boards

began deliberating the proposed model in

October 2009 with an eye towards issuinga new accounting standard in final form in

mid-2011. The new standard would require

adoption potentially as early as 2012/2013.

While there may be some slippage in these

dates, many companies will need to start

addressing these issues now in order to beprepared for the change.

At a minimum, compliance with theproposed standard will require companiesto thoroughly overhaul their legacyaccounting systems, processes andcontrols. Importantly, the proposed

standard will also have a significantimpact on a company’s operating results,financial ratios, and potentially their debtcovenants.

For most companies, the cost of realestate represents one of their largest costitems. And yet, the existing corporate realestate function may have been designedto support a very different operationalstructure compared to what exists todayor one which was originally motivated by

financing or tax considerations that nolonger apply.

For some companies, the proposedlease accounting standard will present just another compliance issue entailingsignificant readiness costs that will needto be managed. Such costs will includeeducation, the need to size the impact ofthe proposed standard on the financialstatements, robust systems upgradesand implementation of new controls. Forothers, in addition to the complianceissue, the proposed standard will be a

much-needed catalyst for revolutionarychange in their overall corporate realestate strategies. Thus, the lease project,coupled with change impetus from othercurrent economic, tax and businessissues, may drive some companiesto radically overhaul their real estatestrategies.

A detailed summary of the key provisionsof the lease project as well as a practicalexample have been provided as an Appendix to this paper.

Executive summary


4/24PricewaterhouseCoopers2

PricewaterhouseCoopers1 has a network of real estateprofessionals that can assist you with:

Real estate strategy and accounting advisory

Training, planning and implementation assistance with regard to new lease•standard

Analysis of needs and market trends•

Analysis of, or assistance with, evaluating financial and strategic impact of new•lease project

Tax and transaction support

Analysis of tax implications and structuring opportunities with respect to new•lease standard

Sale-leaseback transactions•

REIT spin-offs of corporate real estate to unlock shareholder value•

Tax planning transactions•

Systems and processes

Process/control change consulting/implementation planning with respect to•impact of new lease project

Strategic information systems planning•

Gap analysis & system selection•

Technology integration & implementation•

Operational effectiveness and cost containment

Lease expense “audits” for potential recovery•

Process re-design & leading practices in corporate real estate•

Benchmarking and performance monitoring•

Spend analysis, strategic sourcing, outsourcing effectiveness•

Operational & organisational effectiveness•

Valuation/market analysis

Real estate and lease portfolio valuation•

Market studies•

Valuation analyses in conjunction with accounting requirements•

If you would like further information on the proposed lease accounting model orassistance in determining how it might affect your business, please speak to yourregular PwC contact. A list of PwC contacts has also been provided at the back of

this publication.

How can we help?

1 “PricewaterhouseCoopers” and “PwC” refer to the network of member firms of PricewaterhouseCoopers Inter-national Limited (PwCIL). Each member firm is a separate legal entity and does not act as agent of PwCIL or anyother member firm.



Some fundamental questions

As you assess your current corporatereal estate strategy, there are a numberof fundamental questions that come intoplay, such as:

Why does your company lease or own•in particular situations?

What are the alternatives to leasing?•

What are current market opportunities•

(e.g., lease rates/purchase prices) andhow would they affect your real estatestrategy?

How do (local) taxes factor into your•corporate real estate decisions?

How does your company manage•occupancy costs today?

What is the potential impact of•the proposed lease model on yourcompany?

What changes will your company need•to make to manage the process?

Do your company’s existing systems•have the capabilities necessary toapply the proposed lease standard?

The “stake holders”

Corporate real estate activity affects anumber of key functional areas and anyreconsideration of your approach shouldinclude, at a minimum, members of eachof the following key constituencies:

Accounting/reporting•

Treasury•

Legal/regulatory•

Operations•

Tax planning and reporting•

Information/systems•

Human resources (e.g., impact on•compensation agreements)

Each of these stake holders are potentiallyimpacted by the proposed accountingstandards. Many of these impactsare readily apparent; for example, theimpact of the proposed lease accountingmodel on financial reporting and debt

covenants. Other impacts may be lessobvious or may be specific to a particularindustry including, for example, impacton compensation tied to companyperformance or on legal/regulatory capital. Accordingly, it is essential for companiesto seek broad participation in theprocess of identifying and addressing thepotential impacts of the proposed leaseaccounting standard. Best practice is toform a “steering committee” comprisingmembers of each of these constituencies.

...it is essential for

companies to seek

broad participation

in the process of

identifying and

addressing thepotential impacts

of the proposed

lease accounting

standard.



Operational issues

A company’s need for corporatereal estate is driven in large part byboth its current and planned physical

requirements. Space needs can changedramatically over time with such changesdriven by a variety of factors includinggrowth/contraction plans, potentialacquisitions, productivity improvements,and physical obsolescence of space.Further, local demographics may changeneeds for particular locations. Theseissues will vary significantly from companyto company and perhaps even

on a property type by property type basis.The following examples help illustrate thediversity of potential issues based on a

company’s operations:

Example 1—Retail company

A retail company typically requiresseveral different types of property for itsoperations including (i) store locations, (ii)

warehouse locations and (iii) key corporateoffices in central business districts.

Example 2—Bank

A bank typically requires several differenttypes of property for their operationsincluding (i) bank branches, (ii) processingoperations (often in fungible officespace in suburban markets) and (iii) keycorporate offices in central businessdistricts.

Generally, a company is more likely tolease real estate when its long-term

property needs are unclear, operational

Factors that impact corporate real estate strategy

The proposed standard will be the catalyst for companies to take a fresh look at factorsthat impact corporate real estate strategy.

Many of these factors drive the decision to lease a particular asset versus buying it.For many entities, the original reasons for these decisions and policies are no longerrelevant. For example, transactions previously structured for off-balance sheet benefit ata higher cost compared to straight borrowing may no longer be optimal.

Corporate

real estate

stategy change

Financing

issues

Effective

management

of corporate

real estate

Government

and budgetary

issues

Regulatory

issues

Operational

issues

Economicconditions

Tax

Considerations



flexibility is highly desirable and expectedaccess to acceptable alternatives is good.Leasing has also historically carried theadded advantage of providing companieswith a form of off-balance sheet financing.Conversely, a company is more likelyto buy when the company’s long-termproperty needs are clear, the need forspecific properties are expected to bestable and long-term, specific assetsare needed and there are concerns with

respect to the availability of acceptablealternatives.

Of course, there are many operationalreasons why companies rent ratherthan own that may be unrelated to theaccounting or even to the economics. Onesuch reason frequently cited is that leasingallows tenants to avail themselves ofprofessional property management. Doesa bank, for example, want to maintain astaff of engineers, maintenance or otherpersonnel necessary to manage the day-to-day issues surrounding managementof real estate? In these circumstances, wemay begin to see an expansion of serviceoptions that may allow incentivisedproperty management to be done on acontract basis.

Overriding operational considerationsare often the impact of market practiceor practical availability. Certain types ofproperties (e.g., retail store locations) maybe “unique” and not generally availablefor purchase, whereas commercial officespace may be more fungible and, in somecases, also available for purchase.

With the loss of off-balance sheetaccounting, companies that presentlylease may instead opt to own. Wehave already begun to hear of potentialpurchase transactions involving single-tenant office buildings. It is possible thatcondominiumisation of certain propertytypes may also increase as a result of theproposed lease model. However, this trendwill be affected by “why” the companiesare leasing, as discussed previously. It isalso likely to vary significantly by propertytype. For example, this is more likely tooccur in more physically static situations

such as individual floors or blocks of floors

in large office buildings or with single-tenant retail sites, both of which may befunctionally independent. It is less likelyto occur with partial floors or in malls/ strip centres which are not functionallyindependent and may frequently requirereconfiguration of space to accommodatea different tenant mix.

As discussed previously, today, in manycases, companies “outsource” theircorporate real estate lease administration

because commercial real estate serviceproviders provide this service relativelyinexpensively (in order to gain access tomore lucrative transaction activity such asleasing commissions) which is more costeffective than doing such administrationin-house. However, the additionalinformation needed to account for leasesunder the proposed lease model (such asthe expectation of exercising of renewaloptions or projections of retail store salesand the impact of same on percentagerents to be paid) may be too sensitive to

the company’s lease negotiating positionto allow such interested parties to havethe necessary access to the information inorder to prepare the required accountingdocumentation (e.g. agent of landlord maynot get commission info).

Economic issues

Recent economic turmoil has significantlyimpacted property values, and marketrents, in many cases, have declineddramatically. Vacancy rates in some

property types and markets are rising—sometimes significantly, but not uniformlyacross markets. Further, today manylandlords are struggling with decliningcash flow from operations, liquidity issuesand debt maturities. As a consequence,landlords may be more willing to discussasset sales and lease modifications—sometimes trading a lower rent inexchange for a longer lease.

The current environment presents bothpotential challenges and opportunitiesfor users of corporate real estate. Current

rents being paid pursuant to existing

leases may be significantly above current“market” asking rents and landlords willlikely be resistant to changing currentterms. In certain cases, opportunities tobuy assets at favourable prices may exist,while in other cases, negotiating rentconcessions currently or through “blendand extend” type transactions may yieldlower “all-in” occupancy costs.

Financing issuesFor many industries or individualcompanies, financing options may belimited or expensive. As a result, leasing,historically, may have been the only optionavailable, or, it may have been cheaperthan other sources of financing availableto the company.

However, depending upon the creditquality of the company, corporate realestate departments may now want toreconsider purchasing assets that werepreviously subject to a lease. Whenunderwriting the amount and terms ofa commercial mortgage to a landlord,lenders will consider factors such as debtyields, coverage ratios, loan-to-value,the length of lease terms, likelihood ofrenewal and credit quality of the tenant ortenants occupying the property. In somecases, the landlord cannot effectivelyfund property improvements necessaryfor the current operation of the property. A corporate real estate user may havea better credit profile and lower costof capital as compared to a particular

landlord or to the “average” credit in apool of tenants at a site. If the user iscommitted to a longer term use of theproperty, such user may benefit fromobtaining financing using its own creditrating versus the landlord’s which maybe lower as a result of current marketdifficulties.

Tax considerations

The proposed standard will reduce thedifference in the accounting effects of

leasing versus owning an asset, and



companies may be more inclined topurchase assets rather than lease them. As companies take a fresh look at futurereal estate investment decisions andmodel the proposed accounting standardfor existing leases, they may re-evaluateprevious decisions or identify assetsthat no longer meet their needs. Whilethe proposed accounting standard isunlikely in and of itself to cause significantdisposition of assets, such disposition

may be the result of re-examining theportfolio.

Income tax considerations often playeda significant role in many corporatereal estate strategic decisions. A clearunderstanding of the tax motivation andimplications for both of the counterpartiesis critical as these factors may significantlyaffect the pricing as well as the range oftransactions the parties may be willing toconsider. In addition, the economic issuesaffecting either side of a transactionmay have radically changed since thetime when the decisions were firstmade. A company with net operatingloss carryovers may be more willing toundertake substantial restructuring. Onewith expiring capital loss carryovers maybe seeking opportunities to generategains. Tax sensitive or tax orientedtransactions by entities with significantowned real estate are generating moreinterest once again—including sale-leasebacks, joint ventures, spin-offs andREIT conversion transactions.

There may be additional tax issuesassociated with the proposed lease

standard, such as sales tax or propertytax consequences. Companies will needto evaluate the unique tax provisionsfound in each country and locality, todetermine the various consequences totheir particular case due to the proposedleasing standard.

The proposed lease accounting modelmay have other impacts on the taxtreatment of leasing transactions, astax accounting for leasing is oftenbased on accounting principles in many jurisdictions. Given that there is no uniform

leasing concept for tax purposes, theeffect of the proposed lease accountingmodel will vary significantly, depending onthe jurisdiction.

Items that may be impacted include theapplicable depreciation rules, specificrules limiting the tax deductibility ofinterest (for example, thin capitalisationrules, percentage of EBITDA rules),existing transfer pricing agreements,sales/indirect taxes and existing leasing

tax structures (in territory and cross-border). A reassessment of existingand proposed leasing structures shouldbe performed to ensure continued taxbenefits and management of tax risks.

Even where tax does not follow theproposed lease accounting model,management may see an increase in thechallenges of managing and accountingfor newly originated temporary differencesin the financial statements which may leadto additional deferred taxes.

Timely assessment and management ofthe potential tax impact will help optimisethe tax position, by enabling entities toseek possible opportunities and/or reduceany tax exposure.

Regulatory issues

Since the standard is still underdiscussion, regulatory effects may emergewhen the standard is final and its effectsare better understood. What is uncertainat this point is how regulatory agencieswill come to grips with how this changewill impact risk-based capital requirementsand other key regulatory metrics. Inlight of the balance sheet gross-up andacceleration of expenses relative tostraight-line rent expense typical of anoperating lease today, the effect of thechange could be very significant to banks/ broker dealers and other regulated entitieswhose capital ratios and/or other metricsare closely monitored and which wouldbe adversely affected in many cases ifcomputed under the proposed modelwithout adjustments.

Timely assessment

and management

of the potential

tax impact will

help optimise the

tax position, byenabling entities

to seek possible

opportunities and/

or reduce any tax

exposure.



Intercompany issues

Many heavy corporate real estate users

use a central real estate “holding entity”

for owned and “leased in” property and

then provide for intercompany charges

to the other consolidated subsidiaries.

In some cases, the structures have been

created to take advantage of beneficial

pricing (allowing companies to aggregate

subsidiary needs to take bigger spaces,

obtain operating synergies and to negotiate

better terms) and for operational ease

(allowing corporations with multiple

subsidiaries to be flexible in allocating

space between these units) or are driven

by tax considerations (e.g., private

REITs with beneficial state tax impacts).

In some cases, companies executed

intercompany leases, but, in others, no

formal arrangement existed and costs

were allocated through an intercompany

expense charge. Under the proposed lease

standards, these intercompany transactions

will need to be reflected on the separate

company’s books and the documentationof the arrangement is likely to be much

more important since it will drive the value

of assets and associated liabilities for

entities reporting on a stand-alone basis.

Governance and budgetaryissues

Some historical decisions to lease versusbuy may have been driven by approvalprotocols and budgetary factors. Forexample, where a company is growing

rapidly it might have been faster and moreefficient to execute a lease of real estateor equipment rather than going throughthe process to approve the purchaseof a capital asset. In addition, internalbudgeting may have led to a leasing biassince the upfront cash outlay is muchlower than a purchase. If the approvalrules follow the new lease model, anoperating lease may now need the samelevel of approval as an outright purchase.

Managing corporate real estate

In many organisations today, the corporatereal estate department is viewed as moreof an administrative function or costcentre rather than a part of a strategicfunction or a competitive advantage.Further, corporate real estate departmentsare frequently undermanned and oftendo not have the infrastructure or systemsto effectively track and manage the realestate for which they are responsible.

Further, many companies have grownlarger through acquisition, and legacysystems are often “balkanised” thuslimiting management’s ability tounderstand and manage real estate ona company-wide or even country-widebasis. Such systems are rarely optimalfor a company’s current operations, norare they fully integrated into the largerenterprise-wide systems, includingaccounting and reporting. In addition,because of the length of a typical realestate lease, current management may

not be aware of the original rationalfor specific decisions, some of whichmay no longer exist due to changingcircumstances.

In some cases, corporate real estatedepartments may have the responsibilityfor tracking the real estate but not enoughresources and focus to identify andmanage excess capacity, identify andseek reimbursement for overcharges forlease operating costs (e.g., CAM and billback overcharges) and/or minimise othercash real estate occupancy costs. Finally,

for many companies, existingtracking systems are informal, incompleteor inaccurate. These “tracking systems”might be nothing more than a drawerfor storing copies of leases, a notebookcontaining lease abstracts, Excelspreadsheets and non-integrated or out-of-date software applications.

With respect to asset managementsystems, today, many companiesare still accounting for their leases ofcorporate real estate using Excel and



the accounts payable systems withno formal corporate real estate assetmanagement systems. Even for the moresophisticated corporate real estate groupsthat have asset management systems,these systems are freestanding, with nointegration with the company’s accountingsystems. Accounting for leases underthe proposed lease standard will requiresignificant changes to existing informationsystems as well as new processes and

controls. In many cases the informationnecessary to make the various decisions,estimates and periodic remeasurementshas not previously been reported toaccounting or treasury on a timelybasis (such as changing expectation ofrenewals or changing expectations onfuture contingent rents). For high volumecorporate real estate users, from a long-term sustainability perspective, it willlikely be a necessity that such systems/processes be largely automated and fullyintegrated into the companies controlstructure and accounting systems.

Given all of the above, these changeswill necessitate a potentially significantcultural change as well as an operationalone.

Internal controls and processes

Many entities in the past have notneeded robust processes and controlsfor leases other than around their initialclassification. In addition to eliminatingoperating lease accounting, existinglessee accounting models (absent amodification or exercise of an extension)did not require leases to be periodicallyrevisited. The proposed new standardwould require that leases should beremeasured for changes in estimates(for example, for changes in expectedlease term or expected contingent rentpayment) and will require entities to (re)design processes and controls to ensureproper management and accounting of alllease agreements.

Initial recording on balance sheet andannual reassessment of lease terms andpayment estimates may require significantand complex changes to existing

processes and internal controls, includingsupport for significant managementassumptions. Monitoring and evaluatingthe estimates and updating the balancesmay also require more resources thancurrent accounting.

Timely assessment and management ofthe impact on processes, controls andresource requirements will help controlyour business and reduce reporting risks.

IT and lease accounting systems

IT and lease accounting systems in themarketplace are based on the existingrisks and rewards concept; they will needto be modified to the proposed right-of-use concept. Obviously, systems designedto meet the needs of this potential newpronouncement have not yet been createdand must be developed. Lessees willhave to account for and manage leaseagreements differently (including existingoperating lease agreements). They mayneed to implement contract management

systems for lease agreements andintegrate these with existing accountingsystems. Lessees will need to identify andimplement IT and accounting solutionsthat meet their future needs.

Lessees may expect lessors to providethem with the necessary informationto comply with the proposed standard.However, lessors may not have, or maybe unwilling to provide, data required bylessees. Consequently, lessees will needto capture such information themselvesand may, therefore, need to modify theirsystems.

Timely assessment and management ofthe impact on IT and lease accountingsystems will help reduce business andreporting risks. We understand that someof the ERP systems are in the processof evaluating upgrades and solutionsthat will allow for an integration of theaccounting for the new lease project andpotential controls thereon, however, suchdiscussions are only at their conceptualand planning phases pending the issuanceof the Exposure Draft.



Financial reporting and impact on ratios

The financial statements will requirerestatement for the effect of the changes.The effects of the proposed leaseaccounting model should be clearlycommunicated to analysts and otherstakeholders in advance.

Ongoing accounting for leases mayrequire incremental effort and resourcesas a result of an increase in the volume

of leases recognised on balancesheet; there is also likely to be a needfor regular reassessment of the leaseterm, contingent rentals, residual valueguarantees, or the impact of purchaseoptions.

The impact of change will not be restrictedto external reporting; internal reportinginformation, including financial budgetsand forecasts, will also be affected.

The proposed lease model will changeboth balance sheet and income statementpresentation. Leverage and capital ratios

may suffer from the gross-up of balancesheets. Rent expense will be replacedby depreciation and interest expense.In addition, the expense recognitionpattern may change significantly. Thiswill negatively impact some performancemeasures, such as interest cover, butimprove others, such as EBIT/ EBITDAand cash flow from operations, with nochange in the underlying cash flows orbusiness activity. In addition, continuousremeasurement will increase volatility ofkey ratios.

Timely assessment of the proposal’simpact on covenants and financingagreements will enable managementto start discussions with banks, ratingagencies, financial analysts and otherusers of the entity’s financial data. Entitiesanticipating capital market transactionsshould consider the effects on theirleverage ratios. Other agreements basedon (entity-specific) key performanceindicators will require reassessment and,potentially, adjustment (for example,compensation agreements).

The opportunity

The last five years have seen a host ofchanges facing corporate real estateorganisations. From cost managementto outsourcing, from systems changesto designing the workplace of thefuture, the role of the corporate realestate department has never beenmore complex. Nevertheless, the roleof corporate real estate as a strategicfunction within the enterprise has beenspotty at best. Simply put, many SeniorExecutives or Boards of Directors havenot viewed their corporate real estatedepartments as a material element indriving the success of an organisation. Atbest, corporate real estate departmentsare viewed as a necessary, but largely asan administrative function, having littlebearing on the overall success or failureof the company. Given the current state ofplay—some would say “who would thinkotherwise?”

By some estimates, real estate leasing

accounts for nearly two-thirds (2/3) of allleasing activity. As part of our discussionswith client and industry representativesaround the changes which may be comingas part of the joint FASB/IASB leaseaccounting project, we are beginningto see senior management at manycompanies target their corporate realestate strategy and operations for a majorrenovation and update in order to preparefor the new GAAP requirements, as well asto be more nimble in the current economicclimate.

The proposed lease standard is notexpected to allow for grandfathering ofexisting leases. Management will needto catalogue existing leases and gatherdata about lease term, renewal optionsand payments in order to measure theamounts to be included on the balancesheet. Gathering and analysing theinformation could take considerable timeand effort, depending on the numberof leases, the inception dates and theavailability of records. Internationaloperations could make this not onlymore voluminous but could introduce

Simply put, many

Senior Executives

or Boards of

Directors have

not viewed their

corporate realestate departments

as a material

element in driving

the success of an

organisation.



additional issues such as contracts indifferent languages and leases affected bylocal regulations. In many cases, originalrecords may be difficult to find or may notbe available. In addition, companies withinternational operations may need to dealwith leases written in different languagesand with the potential impact of localstatutes in applying the standard. Forexample, in France certain local statutesprovide the lessee with an automatic rent

controlled renewal option irrespectiveof whether one is contained in the leaseagreement itself.

While the adoption of the new standardremains at least 18 months away,

organisations are well-advised to beginconsidering the impact of these changesnow, and to put into motion the stepsneeded to prepare your organisationfor the change. Amongst the technicalaccounts, operational, and systemchanges outlined in this document, wepredict that changes to your CorporateReal Estate role will also be needed,and the lease accounting changes beingproposed should provide the “Catalyst

to Change Corporate Real Estate.”Beginning the process early wouldensure that implementation of a futurestandard is orderly and well-controlledand that data on new leases written

before implementation of the changes iscaptured from the outset. In addition, itmay allow entities to consider potentialadoption strategies, negotiation strategychanges for new leases and potentially torenegotiate existing agreements in orderto reduce the impact of adoption.

The chart that follows depicts a potentialtransition plan with respect to evaluatingthe effects of the proposed lease model.Incremental corporate real estate strategy

and systems changes would be doneconcurrently with this plan.

IFRS tomorrow...

Establish policies andprepare financials results Embed the new standard

•

Go live and businessas usual

• Reporting updates

• Ongoing updates

• Ongoing monitoring

•

Issues resolution• Business strategy changes

• System changes/upgrades

• Execution

• Planning for the future

Final standard (2011) Effective date (2012/2013)Exposure draft (after mid-2010)

•

Training/awareness• Preliminary assessment

• Strategic planning for

the future

• Process and technology

readiness

Assess impact anddetermine strategy

Phase I Phase II Phase III

Project management, communication, knowledge transferIFRS today...

Lease project timeline/path forward

We urge you to consider the timeline above in the context of

your business.



Appendix—Detailed discussion of lease projectfrom lessee’s perspective

Status of the joint lease project

In this Appendix, we will summarise thecurrent direction of the project as ofJune 30, 2010 based on the DiscussionPaper issued in March of 2009 as well asconclusions reached by the Boards (FASBand IASB) as part of their redeliberationsof particular issues since. We expectthat the actual Exposure Draft that willbe issued will be consistent with the

concepts contained herein, but differencesin the final Exposure Draft may arise,and further differences may arise as theBoards redeliberate the Exposure Draft inlight of comment letters they receive onthe Exposure Draft.

Background

Leasing is an important and widely-usedsource of financing. It enables entities,from start-ups to multinationals, to acquirethe right to use property, plant, and

equipment without making large initialcash outlays.

Entities currently account for leases as

operating leases or finance leases. Lease

classification is based on complex rules.

Though many operating leases provide

nearly the same risks and rewards as

outright ownership, neither the leased asset

nor the obligation to pay for it is recorded

on the balance sheet. Rather, rent expense

is recorded on the income statement on

a straight-line basis throughout the lease

term under current GAAP.

Many observers have long believed thatthe current lease model is not consistentwith the current conceptual framework,which provides the underpinnings forinternational accounting rules. They arguethat current guidance allows lessees tostructure lease transactions to result inoperating lease classification. Critics also

point out that the current standards permitsomething as illogical, for example, as acommercial airline company to recogniseno airplanes on its balance sheet.

As part of their global convergenceprocess, the Boards have been workingto create a single, comparable, worldwideleasing standard. The project wasintended to build on previous workcontained in the 1999/2000 white paperentitled “G4+1 Special Report, Leases:Implementation of a New Approach.” TheBoards issued a joint discussion paper

in March 2009. They currently expect torelease an Exposure Draft in Q3 2010 anda final standard around a year later.

The project was initially expected tocover only lessee accounting with lessoraccounting to be addressed concurrentlywith the joint project on RevenueRecognition. However, in responseto concerns raised that subsequentconsideration of lessor accounting could

result in changes to the lessee model,the Boards now expect the final standardto address the overall lessor model butpotentially have a different adoption date.

In the Discussion Paper, the IASB andFASB consider two approaches that couldapply for lessors when using the ‘rightof use’ concept. In the first approach(‘derecognition approach’) the asset isderecognised from the balance sheetand a receivable for the right to receive

rental income and a residual value arerecognised. In the second approach(‘performance obligation approach’) alease contract represents a new right. Theasset will stay on balance in the lessors’financial statements and a separateasset is recorded for the right to receiverental income and a liability is recordedfor the obligation to provide use of theasset to the tenant. The Boards have inthe meantime decided on a lessor modelwhich is a hybrid approach where theperformance obligation approach willbe used where the lessor is exposed tosignificant risks and benefits associatedwith the underlying asset, and thederecognition approach where the lessoris not exposed to significant risks andbenefits. It is worthwhile to know thatthe IASB tentatively decided in January2010 to remove lessors and lessees ofInvestment Property measured at fairvalue from the new leasing accountingproposals.

Effective date

to be determined

perhaps 2012/2013

2009 2010 2011 2012 &

beyond

Discussion

paper issued

March 2009

Comment

period ended

July 2009

Exposure draft

expected after

mid 2010

Final standard

expected

mid 2011

Redeliberations

began October

2009

Rediliberations

expected to

begin Q4 2010

The time line

The project time line and reasonable reaction time periods for tenants/landlords to evaluate potential impacts are as follows:



Scope

The Boards have preliminarily determinedthat the scope of any proposed standardwill include leases of property, plant andequipment and will not include leasesof intangible assets. The Boards also

preliminarily decided to exclude fromthe scope: (1) leases to explore for oruse natural resources (such as minerals,oil, and natural gas), and (2) leasesof biological assets. The scope of aproposed standard will therefore broadlyalign with current IFRS.

PwC observation: Similar to otherstandards, the proposed lease standardwould not apply to immaterial items. Although a single item might beimmaterial, items of a similar nature might

be material in the aggregate (that is, onecomputer lease might be immaterial,but 10,000 computer leases might bematerial). For leases determined to beimmaterial to the financial statementsin the aggregate, management mayconsider developing a policy similar tocommonly used property and equipmentcapitalisation policies.

Short-term leases and non-core assets

The Boards considered the potentialexclusion of short-term leases and leasesof non-core assets. Factors includedin their considerations were the costof applying the model, the difficulty

in defining non-core assets, and thepotential structuring opportunity that anexclusion could create. They tentativelydecided not to exclude short-term leasesor leases of non-core assets becausethese leases may give rise to materialassets and liabilities and, if so, excludingthem would run counter to the Boards’objective of bringing the rights andobligations on the balance sheet.

Although the Boards decided not to grantan exclusion for short-term leases, theyreached a preliminary decision to ease the

burden in accounting for them. For leaseswith a maximum possible term (includingall extension options) of less than 12months, lessees could use a simplifiedform of lease accounting: the lesseewould recognise a lease asset and liabilityequal to the gross payments remaining oneach lease.

PwC observation: Because of the shortduration of the leases that qualify for thesimplified approach, the time value ofmoney associated with these short-termleases would be ignored, as a practical

expedient.

Key provisions

We will discuss the following expected key provisions of the standard and provide anexample of the impact on a real estate user (lessee) in a hypothetical lease scenario.



Lessee accounting

The basic model

The Boards are expected to propose aright-of-use model for lessee accounting.This model requires the lessee torecognise an asset representing its “rightto use” the leased item for the leaseterm and a corresponding liability forthe obligation to pay rentals. Under thisapproach, all leases would be accounted

for in a similar manner; the classificationsof finance and operating leases usedtoday would be eliminated.

The Boards believe the right-of-usemodel is the most consistent with theirconceptual frameworks and increasesthe transparency of lease accounting.Because leases are commonly viewedas a form of financing, the obligationsrecognised on the balance sheet underthe right-of-use approach would beconsistent with how businesses reflectother financing arrangements.

PwC observation: The right-of-use modelmight change how entities negotiateleases, and it might affect lease-versus-buy decisions. However, we believeleasing will continue for a variety ofbusiness reasons:

Leasing provides more flexibility than•outright ownership;

Certain leasing structures are more tax•efficient than direct ownership; and

Leasing often provides effective•

financing to entities whose financingoptions are otherwise limited. Inaddition, for substantial items, suchas real estate, leasing is expected tocontinue as a viable option becausemany entities prefer not to own thesetypes of assets.

Leasing may be more appropriate for•space users who occupy only a smallportion of a larger facility (e.g., tenantin a regional mall) or for a period whichis substantially shorter than the usefullife of the asset (e.g., five years for anoffice building with a useful life of 40years or more).

Initial measurement

Lessees initially would measure theright-of-use asset and the obligation topay rentals at ‘cost’. Cost is defined asthe present value of the lease payments,including initial direct costs incurred bythe lessee. The Boards have defined initialdirect costs as incremental costs directlyattributable to negotiating and arranginga lease. They have directed their staffs toprovide additional guidance to illustrate

which costs could be considered initialdirect costs.

Present values would be determinedusing the lessee’s incremental borrowingrate as the discount rate. If the rate thelessor is charging to the lessee is readilydeterminable, this rate can be used inplace of the incremental borrowing rate.

PwC observation: The Boards haveshown a preference for the use of theincremental borrowing rate recognisingthat, for real estate and other forms of

leases currently treated as operatingleases, the lessee will not often be in aposition to determine the interest ratethe lessor is charging to the lessee.Nevertheless, in circumstances where itis easily determined (such as full payoutleases and hire purchase transactions) theinterest rate the lessor is charging to thelessee may be used as a practical proxyfor the incremental borrowing rate.

“Gross” versus “Net” leases—period

costs to be excluded

“Executory costs” are frequently includedin the quoted lease terms (especiallyfor real estate) and need to be removedfrom the lease payments that are usedto generate the value of the initial leasedasset and liability. Executory costs is anaccounting term used to describe suchthings as real estate taxes, utility expense,maintenance, property management,snow removal, landscaping, security andcleaning that may be included in the leasepayments. These costs are operatingperiod costs and should be reflected inthe period incurred but are expected to

be excluded from the rent in applying theproposed lease accounting model. There

are several different types of leases thatare common and each may have someunique issues to deal with. Some of theseare described below:

Net lease• —These types of leases arecommon for retail/industrial propertyand single-tenant property where thetenant is either billed by the lessor forexecutory costs incurred (on a prorata basis for multi-tenant properties)or such costs are paid directly by the

tenant. In such leases the tenant bearsthe risk of all the upside/downside withrespect to changes in the executorycosts.

Base year lease• —These leases arecommon for office property wherethe tenant’s rent is set during the firstyear of the lease, i.e., the “base year,”which includes executory costs (on apro rata basis for multi-tenant leases).In subsequent years, the tenant paysadditional amounts for executory coststo the extent they exceed the tenant’s

pro rata share of the aggregate ofthose expenses in the “base year.”In these leases, tenants bear all theaggregate downside in the case ofrising prices and the lessor gets anybenefits of aggregate efficiencies thatreduce overall costs.

Gross lease• —Gross leases havehistorically been very simple. Thequoted base rent includes allexecutory costs. In such leases, thetenant bears the risk of all the upside/ downside associated with cost

changes. In many cases, especially forreal estate, the tenant neither knowsnor (previously) cared what theseexecutory costs are—their focus issolely on the all-in cost of occupancy.

PwC observation: Stripping outexecutory costs was not significant inmany cases under the current leaseaccounting model but will becomesignificant under the proposed leasingmodel. Therefore, management may needto obtain information with respect toexecutory costs from landlords or to find

ways of estimating them.



Subsequent measurement

The Boards have preliminarily agreedthat the right-of-use asset should besubsequently measured at amortisedcost. The expense recorded would bepresented as amortisation expense ratherthan rent expense.

The lessee’s obligation to pay rentalswould also be subsequently measured atamortised cost using the effective interest

rate method under which paymentswould be allocated between principaland interest over the lease term. Interestexpense determined under that methodwould be higher in the early years of alease compared to the current straight-line treatment for rental expense under anoperating lease.

Lease term

Under existing standards, optional periodsare considered part of the lease term if thelessee concludes at lease inception thatit is ‘reasonably certain’ to exercise the

right to renew the lease. Under the right-of-use model, lessees would be requiredto estimate the ultimate lease term andperiodically reassess that estimate. Adetailed examination of every lease ateach reporting date would not be required. A lease’s term would be re-examined onlyif changes in facts and circumstancesindicate that a revision may be needed.

The lease term is proposed to be defined as

the longest possible term more likely than

not to occur. In estimating the lease term,

all relevant factors should be considered,

including intentions and past practices.For example, consider a lease with a non-

cancellable five-year term and two five-year

renewal options. The minimum contractual

term of five years is more likely than not to

occur (the probability is 100 per cent that

the lease will cover at

least the five-year period). The lesseewould also need to consider whether the10- or 15-year terms available as a resultof the renewal options are more likelythan not to occur. Once the lessee hasdetermined which lease terms are more

likely than not to occur, the longest ofthose terms would be the lease term usedto account for the lease.

Purchase options

The Boards tentatively decided thatpurchase options would be accountedfor similar to the accounting for optionsto extend a lease and should not berecognised as separate assets. A lesseewould therefore need to estimate whetherthe purchase option is more likely than notto be exercised and revisit this judgment iffacts and circumstances change.

Contingent cash flows

Under existing standards, contingent rentsare generally recognised as expenses inthe period they are incurred. The right-of-use model would require that the initialmeasurement of the obligation to payrentals include contingent cash flows,such as ‘turnover rent’, increases in rentsbased on changes in an index (such asCPI), percentage rents that appear inmany retail leases, and residual valueguarantees.

The Boards have preliminarily agreed to

use a probability weighted estimate ofcontingent payments with the clarificationthat a lessee does not have to considerevery possible scenario. Thus, thistechnique encourages the lessee toconsider possible outcomes.

Changes in estimates and

remeasurements

The Boards tentatively decided thatlessees would be required to reassessestimates of lease term and contingentcash flows as warranted by changes in

facts and circumstances. Subsequentmeasurement of the lease obligationwould reflect all such changes in estimate.Changes in the lessee’s obligation due toa reassessment of the lease term wouldbe recognised through an adjustment ofthe right-of-use asset.

Regarding changes in estimatedcontingent cash flows, the Boards havetentatively decided on a mixed model.Where changes in amounts payable undercontingent cash flow arrangements arebased on current or prior period events

or activities, those changes should berecognised in the income statement. All

other changes would be recognised asan adjustment to the lessee’s right-of-useasset. For example, consider a lessee thatenters into a 10-year lease agreementthat includes rental payments based ona percentage of sales. During the secondyear of the lease, the lessee determinesthat the original estimated sales figuresrequire updating. Adjustments in theobligation arising from the true-up ofsales for years one and two would be

recognised in profit and loss. Changes inthe obligation from the updated forecastin sales in years three to 10 would berecognised as an adjustment to the right-of-use asset.

The Boards considered whether thediscount rate should be updated whena remeasurement is required due to achange in estimated term or contingentcash flows. However, it tentatively agreedthat the original discount rate should beused as the discount rate throughout theterm of the lease. The only exceptionwould be a lease with rentals contingenton variable reference interest rates; forall other leases, the accounting wouldbe consistent with that of a fixed rateborrowing.

PwC observation: The requirementto reassess these estimates entailssignificant incremental effort comparedto the current model under which leaseaccounting is set at inception and revisitedonly if there is a modification of the leaseterms. In addition, it may be necessary toinvest in information systems that capture

and catalogue relevant information,and support reassessing lease termsand payment estimates as facts andcircumstances change.



Example

An example illustrating theaccounting implications on theincome statement and the balancesheet, from the lessee’s perspective,is included on the next page:

PwC observation:

Right to use asset amortises over the term of the lease•

Lease obligation acts like a mortgage, each payment is applied to “Principal” and interest. Interest is higher in earlier years.•

Total expense is same over term of the lease•

Total expense for new model is higher then both current model and cash terms•

Lease obligation exceeds net unamortised asset after day 1 until the end of the lease.•

Longer lease terms or lease terms with contingent rents (usually back ended from cash perspective) would have even more•distortion to both current accounting models and cash terms.

Example is for net lease and cash payments exclude executory costs. If base year or gross leases, executory costs would need to•be removed from payments for leases accounting.

Lease Terms and Assumptions:

Lease commenced on 1/1/xx00

Square ft 100,000

Annual initial rent per square ft $20

Initial annual Rent $2,000,000

Annual escalation 2.0%

Assumed incremental borrowing rate 7.00% (10 year rate)

Triple net lease – executory costs paid separately

No extension options

No purchase options

No residual value guarantees

No contingent rent of any kind

(000’s omitted) As of December 31,

Balance Sheet Implications Initialrecognition

XX01 XX02 XX03 XX04 XX05 XX06 XX07 XX08 XX09 XX10

Right to use asset $15,540 $13,986 $12,432 $10,878 $9,324 $7,770 $6,216 $4,662 $3,108 $1,554 $0

Lease obligation ($15,540) ($14,598) ($13,547) ($12,377) ($11,080) ($9,646) ($8,062) ($6,319) ($4,404) ($2,302) $0

Income Statement Implications

For the year ended December 31,

Proposed model: Method XX01 XX02 XX03 XX04 XX05 XX06 XX07 XX08 XX09 XX10 Total

Amortization/depreciation

of right to use asset Straight Line Amort. $1,554 $1,554 $1,554 $1,554 $1,554 $1,554 $1,554 $1,554 $1,554 $1,554 $15,540

Interest expense onlease obligation

Effective interest 1,058 989 911 825 730 625 509 382 242 87 6,358

Total expenses relatedto lease

A $2,612 $2,543 $2,465 $2,379 $2,284 $2,179 $2,063 $1,936 $1,796 $1,641 $21,898

Total

Current accounting model

(straight line)B $2,190 $2,190 $2,190 $2,190 $2,190 $2,190 $2,190 $2,190 $2,190 $2,190 $21,899

Difference - currentperiod

A-B $422 $353 $275 $189 $94 $(11) $(127) $(254) $(394) $(548)

Difference cumulative 422 775 1,050 1,240 1,334 1,323 1,196 942 548 (0)

Cash (Paid in monthlyinstallments)

$2,000 $2,040 $2,081 $2,122 $2,165 $2,208 $2,252 $2,297 $2,343 $2,390

Cummulative Cash 2,000 4,040 6,121 8,243 10,408 12,616 14,869 17,166 19,509 21,899



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Other areas of difficulty

Sale and leaseback transactions

The Boards decided that a sale-leasebacktransaction should be recorded as a saleand leaseback rather than a financing ifit is determined that the underlying assethas been sold. An underlying asset hasbeen sold if, at the end of the lease term,control of the underlying asset has beentransferred and all but a trivial amount

of the risks and benefits associated withthe underlying asset has been transferredto the buyer/lessor. If the sale-leasebacktransaction results in a sale of theunderlying asset and both the sale andleaseback are at fair value, then gains/losses should not be deferred. If, however,the sale and leaseback are not at fairvalue, then the seller lessee should adjustthe asset, liabilities, gains and losses toreflect current market rents.

Subleases

The Boards have decided that the lease-inwould be accounted for under the lesseemodel and the lease-out under the lessormodel. However, there may be some“netting” of parts of the two where there isoverlap. The Boards have now decided ona lessor model which is a hybrid approachwhere the performance obligationapproach will be used where the lessor isexposed to significant risks and benefitsassociated with the underlying asset andthe derecognition approach where thelessor is not exposed to significant risksand benefits.

Presentation and disclosure

The Boards tentatively decided that alessee would present its obligation topay rents separately from other financialliabilities on the face of the balance sheet.The right-of-use asset would be presentedwith PP&E but separately from otherassets that are owned but not leased. Amortisation and interest expense wouldbe separated from other amortisation andinterest expense either on the face of the

income statement or in the notes of thefinancial statements. The Boards will askfor comments in the Exposure Draft as towhether the items discussed herein shouldbe presented on the face of the financialstatements or in the notes to the financialstatements. Both cash repayments andinterest payments would be classifiedin the cash flow statement financingactivities separately in the statement ofcash flows.

PwC observation: The Boardsgenerally require disclosure of keysignificant contract terms, estimatesand assumptions, often includingsensitivity analyses. Because of theincreased emphasis on estimates in themodel, relative to current standards, thedisclosure requirements are expandedsignificantly.

Transition and effective date

The proposed leasing standard wouldbe applied by a lessee by recognisingan obligation to pay rentals and a right-

of-use asset for all outstanding leases atthe transition date. The obligation wouldbe measured at the present value of theremaining lease payments, discountedusing the lessee’s incremental borrowingrate on the transition date. The right-of-use asset would be measured onthe same basis as the liability, subjectto any adjustments required to reflect

impairment. Additional adjustments forprepaid or accrued rents should be madewhen lease payments are uneven over thelease term.

The Boards have tentatively decided tomake an exception for simple leasescurrently accounted for as finance/capitalleases that do not include contingentrents, residual value guarantees or optionsto extend the lease term. Finance/capitalleases entered into prior to the transition

date that meet this exception wouldcontinue to follow the existing finance/ capital lease accounting principles. Thissimplified approach to transition reflectsthe reality that, for many long-term leases,the information needed to adopt theproposed standard retrospectively may nolonger be available.

PwC observation: The lack ofgrandfathering for existing leases willrequire an extensive data-gatheringexercise to take an inventory of allcontracts and then, for each, captureinformation about lease term, renewaloptions, and fixed and contingentpayments. Depending on the numberof leases, the inception dates and therecords available, gathering and analysingthe information could take considerabletime and effort. Beginning the processearly will ensure that implementation ofthe future standard is orderly and well-controlled. Management may also wantto bear in mind the proposed model whennegotiating lease contracts betweennow and the effective date of the new

standard.

The Boards are expected to issue anExposure Draft by September 2010 anda final standard in mid-2011. The Boardshave not discussed the effective date ofthe standard, but presumably it would beno earlier than 2012/2013.



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Notes


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