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Majestic Realty Co. 13191 Crossroads Parkway North City of Industry, CA 91746-3497

Via E-Mail ([email protected]) September 13, 2013 International Accounting Standards Board First Floor 30 Cannon Street London EC4M 6XH United Kingdom Financial Accounting Standards Board Technical Director, File Reference No. 1850-100 401 Merritt 7 PO Box 5116 Norwalk, CT 06856-5116 Re: Comments on Proposed Accounting Standards Revision (Leases, Topic 842) FASB File Reference No. 2013-270 Dear Board Members and Staff: Majestic Realty Co., the largest privately held developer of commercial and industrial real estate in the United States and a significant user of financial statements, submits these comments on the proposed changes to the current U.S. accounting standards on leases presented in the May 16, 2013 proposed Accounting Standards Update. We are writing concerning issues raised by these proposed changes specifically with respect to real property leases. These comments are provided in connection with our participation in the Roundtable to be held on October 3, 2013 in Los Angeles. Majestic Realty Co., founded in 1948, follows a conservative, build-and-hold approach to real estate development. Headquarted in Los Angeles, with regional offices in Atlanta, Dallas, Denver, Las Vegas and Bethlehem, PA, Majestic has built a portfolio of buildings that it owns, manages, and leases. That portfolio, currently over 70 million square feet, includes real estate leases with over half of the Fortune 500. As a private company, Majestic Realty Co. is not required to follow U.S. GAAP. Our concerns with the tentative proposals in the revised Exposure Draft relate to our ability to use and understand the financial statements of our existing and prospective tenants. We are also concerned about the significant unintended changes in economic behavior that

2013-270 Comment Letter No. 400

International Accounting Standards Board Financial Accounting Standards Board September 13, 2013 Page 2 will likely be driven by such sweeping changes in the well-understood and well-performing current standards for real estate lease accounting. Majestic Realty Co., as part of its ongoing business, has many long-standing capital market relationships with institutions ranging from regional and national banks to mutual and life insurance companies, REITs, and fund managers. It is our decades-long experience with commercial and industrial real estate financing that provides much of the basis for the conclusions expressed herein. We are convinced that the revised Exposure Draft, were it to be adopted, would have serious distortive effects in the commercial and industrial real estate industry, and that these distortions would be of sufficient magnitude to negatively impact the national economy. These distortions include disruption of our tenants’ arrangements with their commercial lenders, interference with their ability to comply with common lender covenants, and negative influences on their decision to enter into long-term leases due to accounting compliance and complexity issues. In the U.S. alone, where equity in commercial and industrial real estate exceeds $2.5 trillion, it is authoritatively estimated that reclassifying real estate leases as proposed would increase the apparent liabilities of U.S. publicly traded companies alone by over $1 trillion. This represents an enormous amount of economic activity in which even minor disruptions will have far-ranging consequences that are difficult to contemplate, let alone anticipatorily measure. To put these figures in perspective, $1.5 trillion is the equivalent gross state product of 20 U.S. states. Real estate represents an estimated 73% of the total balance sheet impact of the proposed standard. Getting real estate right – conceptually, legally, and operationally – is essential to getting the Leases standard right. I. The Importance of a Sturdy Conceptual Basis for Real Estate Leasing The current Exposure Draft is built on two simple premises. The first is that all leases are really financings. The second is that all leases are essentially alike. As they pertain to commercial and industrial real estate, both of these premises are faulty. It is disturbing to see these empirically inaccurate premises persist in the latest Exposure Draft, because many commenters on the first Exposure Draft pointed out the problem, and many of the Boards’ members and staff publicly acknowledged that commercial and industrial real estate leases are in fact readily distinguishable from other forms of leasing in important ways. As it stands, however, the entire rationale of the proposed new Leases


International Accounting Standards Board Financial Accounting Standards Board September 13, 2013 Page 3 standard rests on these mistaken assumptions. The simplistic notion that “a lease is a lease,” which conflates the entirety of leasing across all asset classes and treats them all as implicit financings, was set out on page 1 of the original Exposure Draft. This same flawed notion remains central to the revised Exposure Draft. The idea that every lease is really a source of finance is still set forth on page 1. “Leasing is an important activity for many organizations,” the draft states. “It is a means of gaining access to assets, obtaining financing …” The most recent Exposure Draft acknowledges that this is a controversial view, but it does little to resolve the controversy in a conceptually sound way. “Some view all leases as financing transactions,” the Exposure Draft states, at page 220. “Others view almost no leases as financing transactions. Finally, in others‘ view, the economics are different for different leases.” But while recognizing there is absolutely no consensus around the view that all leases are the same or that they are all really financing transactions, the Exposure Draft proceeds to treat all commercial and industrial real estate leases as if they were the same as financings effectively purchasing an asset, and mandates balance sheet treatment similar to the “capital lease” classification in current U.S. GAAP. In fact, as many commenters have amply discussed, all leases are not the same. In particular, some leases are more like ownership, and for that reason the claim on the leased assets they represent belongs on company balance sheets. The existing accounting standards amply acknowledge this “capital lease” distinction. The payment of rent in such cases is more like debt service on an owned asset that is financed with a loan. As a result, under current U.S. GAAP the lessee recognizes an asset and a liability equal to the present value of the payments to be made under the lease. A common situtation which may look very much like effective ownership of an asset financed with debt involves leased assets which significantly depreciate during the lease term. The bundle of economic and legal rights and responsibilities that the lessee obtains in such cases can be tantamount to ownership, because the lessor gets back nothing of real value at the end of the lease. It is not uncommon for such a lease to transfer substantially all the benefits and risks incident to the ownership of property. But the typical commercial and industrial real estate lease is profoundly different. Far from being disguised financings that essentially transfer ownership rights, most commercial and industrial real estate leases reflect a business decision by the tenant to affirmatively avoid the benefits and risks of ownership. The typical industrial or commercial lease of real property has a declining utility each year. It ends in no residual value to the tenant. Ownership of real property, on the other hand, typically includes


International Accounting Standards Board Financial Accounting Standards Board September 13, 2013 Page 4 both capital appreciation and residual value. Moreover, this fact is observable both in the real world and, at least currently, in the world of accounting (one reason that land is never depreciated). The reasons that businesses generally choose to lease industrial and commercial real estate rather than own it are overwhelmingly related to their business needs and strategies, not to a need for external financing. The most common reason a business chooses to lease a warehouse, for example, is that its long-term needs are uncertain. Most businesses require operational flexibility, and leasing provides this – while ownership, in contrast, locks them in. With a lease, optional renewal terms give business tenants discretion to lengthen the period over which they can use the property. The right to assign or sublet can give the same tenant discretion to shorten the term of a lease. Leasing is often much faster and more efficient than purchasing real estate, another highly desirable advantage over ownership. In law, as well as in business and economics, industrial and commercial real property leases are fundamentally different from other kinds of leases and from ownership via financing. Because they are in essence executory contracts, unexpired industrial and commercial real property leases are governed by special rules in bankruptcy. Bankruptcy law treats “unexpired leases” and “executory contracts” differently from liabilities for which the obligations of the parties are fixed and unavoidable. As a matter of legal right, a tenant in bankruptcy has the discretion to reject an industrial or commercial real property lease, even though the lease term has not yet expired. If the tenant chooses to do this, the landlord (the property owner by law) recovers the property, and any claim for unpaid accrued rent is reduced to a pre-bankruptcy unsecured claim. Recognizing the landlord’s ownership interest, special rules compel prompt rejection or assumption in the non-residential context. Further confirming that a commercial or industrial real estate tenant is not a de facto owner financing its purchase, but a user paying for a limited use on a pay-as-you-go basis, U.S. bankruptcy law provides that a landlord’s claim for future rent is capped, generally at one year’s rent. Obversely, U.S. law provides a mature and sensible set of guidelines by which not only bankruptcy courts but also taxing authorities may re-characterize arrangements that the parties have dubbed a “lease” when they are really disguised financings. When an industrial warehouse, for example, is “leased” for what amounts to the entire useful life of the facility, and where the lease is structured to provide the “tenant” with all of the economic value over the useful life of the property, both federal and state courts may recharacterize the arrangement as a financing, discerning that the “tenant” is in fact the


International Accounting Standards Board Financial Accounting Standards Board September 13, 2013 Page 5 owner, and the “landlord” simply a financing vehicle. Currently, U.S. GAAP perfectly reflects this underlying legal reality by deeming such arrangements capital leases which must be recorded on the “tenant’s” balance sheet. The treatment of commercial and industrial real estate leases in U.S. bankruptcy and tax law is consistent with their inherently executory nature. This is not only because, until the expiration of the lease, both the property owner's part of the bargain and the tenant's remain merely partly performed. A further reason that such leases are deemed executory is that the tenant’s obligations under a commercial or industrial real estate lease are typically subject to avoidance under a variety of circumstances. These include the many contractual flexibilities frequently granted the tenant in the lease itself, option terms that can vary the potential lease term substantially at the tenant's election, assignment and sublet opportunities that can effectively shorten the lease term, and the aforementioned special privileges in bankruptcy. For all of these reasons, commercial and industrial real estate leases are quintessentially executory contracts. As is well known, executory contracts normally do not meet the accounting definition of either an asset or a liability. In the SEC's 2005 Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 on Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers, the agency stated this fact plainly: "standard-setters have almost invariably determined that such unperformed contracts should not result in the recording of assets and liabilities." In its Statement of Financial Accounting Concepts 6, FASB sets out its long-standing conceptual definition of liabilities. SFAC 6 defines a liability as a “probable future sacrifice” which the obligor has “little or no discretion to avoid.” The typical industrial or commercial real estate lease, on the other hand, is negotiated for the very purpose of giving the tenant flexibility and discretion. This ability to almost completely escape the risks of ownership is one of the major benefits of leasing real property. Question 2 in the Exposure Draft asks, concerning lessee accounting: Do you agree that the recognition, measurement and presentation of expenses and cash flows arising from a lease should differ for different leases, depending on whether the lessee is expected to consume more than an insignificant portion of the economic benefits embedded in the underlying asset? Why or why not? If not, what alternative approach would you propose and why? This question is important not only because it bears on whether the Type A and Type B leases approach that the Boards have proposed is preferable to a single method of accounting for leases, but also because it directly confronts the essential reality that has made this standard setting such a seemingly intractable challenge. That is, not all leases, and not all asset classes, are sufficiently alike to be accounted for in the same way. And this is true not only when it comes to answering how lease expenses and cash flows


International Accounting Standards Board Financial Accounting Standards Board September 13, 2013 Page 6 should be recognized, measured, and presented, but also when determining whether a particular lease create rights and obligations that meet the definitions of assets and liabilities that are set forth in Concepts Statement 6. For clarity of analysis, Question 2 would have been more precisely put if it had been expanded as follows: 1) Do you agree that the recognition, measurement, and presentation of expenses and cash flows arising from a lease should differ for different leases – for instance, commercial and industrial real estate leases vs. aircraft leases? 2) If so, should the accounting for leases differ depending on whether the lessee is expected to consume more than an insignificant portion of the economic benefits embedded in the underlying asset? Or are there other reasons as well? 3) Do the differences between different types of leases mean that some leases do not create rights and obligations that meet the definitions of assets and liabilities that are set forth in Concepts Statement 6? The answers to these questions, using commercial and industrial real estate as the focal point, are as follows: Yes, the recognition, measurement, and presentation of expenses and cash flows arising from a lease should differ for different leases, for the fundamental reason that the underlying economics of real estate leasing transactions are different. While leases of many types of assets in other industries represent executed contracts that create assets and liabilities under the definitions set forth in Concepts Statement 6, commercial and industrial real estate leases, for the several reasons detailed above, are executory contracts that do not. Yes, one reason that the accounting for leases might differ is that in some cases the lessee can be said to have obtained substantially all the benefits and risks incident to ownership of the underlying asset. This test, and not the hair-trigger standard of “more than an insignificant portion” of the economic benefits, is the relevant distinction. And yes, the differences between different types of leases mean that some leases do not create rights and obligations that meet the definitions of assets and liabilities that are set forth in Concepts Statement 6. As detailed in the preceding analysis, the typical commercial or industrial real estate lease does not meet the definition of a liability in SFAC 6.


International Accounting Standards Board Financial Accounting Standards Board September 13, 2013 Page 7 Neither do such leases create an asset under the terms of SFAC 6, since an essential characteristic of an asset is that “the transaction or other event giving rise to the entity’s right to or control of the benefit has already occurred.” In a commercial or industrial real estate lease, the tenant’s right to enjoy the leased property in the future is completely dependent on the payment of money (rent) in the future. It might be argued that the initial transaction, the signing of the lease, creates a conceptually severable “right to pay the rent,” but if so, the Exposure Draft formula for computing the value of the right-of-use asset effectively values this “right to pay the rent” at zero. (The formula bases the value of the right-of-use asset almost entirely on the present value of the future rent payments. Take away these in futuro transactions, and there is nothing left of the “asset.”) One of the primary reporting problems FASB and IASB are attempting to resolve with the Exposure Draft is off–balance-sheet financing, where the lessee is obligated to the lessor in a manner that most users of financial statements would deem equivalent to a purchase using debt financing. This was the very same problem that U.S. GAAP has already solved with SFAS 13 requiring the capitalization of such leases. To improve upon SFAS 13, rather than rejecting the very sound and workable model on which it is based, the Boards should require further disclosures beyond the current GAAP requirement of footnote disclosure of the minimum lease payments required under operating leases. Such disclosures should include, among other information, improved descriptions of variable rents and of the tenant’s rights relating to extension or termination options. This would be consistent with the objectives described in the Exposure Draft, and would be far more useful to users of financial statements such as ourselves. Like many users, we prefer the current accounting treatment for leases under U.S. GAAP because it permits us to easily adjust the financial statement presentation of a lessee’s operating leases, without having to unwind highly subjective, derived data based on formulas. Since the kinds of adjustments we choose to make may be very different from those preferred by other users, providing all users with sufficiently broad, objectively reliable disclosures in the notes to the financial statements will permit the entire community of users to make reliable adjustments to a lessee‘s financial statements. II. Macroeconomic Effects, Unintended Consequences, and the Importance of Due Process and Field Testing ELFA Study Two years ago, the Equipment Leasing & Finance Foundation concluded a study of the potential economic consequences of the proposed lease accounting standards as set forth


International Accounting Standards Board Financial Accounting Standards Board September 13, 2013 Page 8 in the initial Exposure Draft. While the most recent Exposure Draft differs in some important respects from the original, the ELFA study was particularly focused on the characterization of operating leases as debt, which remains a central element of the proposal. The analysis found that capitalizing operating leases would add an estimated $2 trillion – and 11% more reported debt – to the balance sheets of U.S.-based corporations, with the following negative macroeconomic consequences:

• Through a de facto increase in the cost of debt, the new standard would increase the cost of leasing, which in turn would negatively impact GDP and jobs. Each 50 basis point increase in the cost of debt, the study observed, translates to a potential $10 billion in lost GDP and 60,000 fewer jobs by 2016. • The proposed Leases standard could result in a permanent reduction of $96 billion in the equity of U.S. companies.

These conclusions were based on analysis of the combined financial data for more than 1,800 U.S. companies from Standard & Poor’s CompuStat database, as well as proprietary data from IHS Global Insight. The data were used to develop pro forma financial statements to model the magnitude of the impact of the proposed standard on specific companies, as well as major sectors of the U.S. economy. The modeling effort was augmented and enhanced by a qualitative review of the comment letters submitted to FASB and IASB in response to the original Exposure Draft of the proposed standard, as well as a general literature meta-study. The study predicted wider economic impacts as well. In particular, the study warned, the new rules could change the lessee-lessor dynamic, with lessees opting for shorter lease terms or purchasing assets outright rather than leasing. By making leasing a less desirable option for businesses—both large and small—it would also have far-reaching effects on industries such as construction and manufacturing that are dependent on the leasing industry. Modeling the economic consequences of a 5% contraction of the leasing industry, the study estimated a direct loss of approximately 3,900 jobs in the leasing industry and 15,672 jobs throughout the U.S. economy. Real Estate Industry Study In 2012, a broad coalition of several of the leading nonprofit and commercial organizations concerned with economic growth in the United States and in the health of the real estate sector in particular commissioned a similar study of the macroeconomic impacts of the proposed Leases standard. The organizations that commissioned the study included the National Association of Realtors, the Real Estate Roundtable, Business


International Accounting Standards Board Financial Accounting Standards Board September 13, 2013 Page 9 Owners and Managers Association International, NAIOP Commercial Real Estate Development Association, and U.S. Chamber of Commerce Center for Capital Markets Competitiveness. Unlike the ELFA study, this report focused on only one aspect of the Boards’ proposal: the economic impact of capitalizing real estate operating leases within the United States. This remains a central component of the current Exposure Draft. The study found the following three specific effects of capitalizing operating leases:

• Reduced spending by companies necessitated by deleveraging in order to deal with apparent increases in liabilities

• Increasing borrowing costs for lessees with higher debt ratios

• Reduced value of real estate resulting from contraction of the economy

In its Best Case scenario, the study found that the proposed Leases standard would destroy approximately 190,000 U.S. jobs, or more than the total employment of both Google and Ford Motors. U.S. GDP would be reduced by $27.5 billion annually, which is larger than the Gross State Product (GSP) of Vermont. Household earnings would be reduced by $7.8 billion annually. In the Worst Case scenario, there would be a loss of 3.3 million jobs, or the combined global employment of IBM, UPS, McDonalds, Target, Kroger, HP, PepsiCo, Bank of America, GE, and General Motors. U.S. GDP would be lowered by $478.6 billion annually, equivalent to the combined GSP of Minnesota, South Carolina, and Montana. Household earnings would fall by $135.2 billion a year, or $1,180 per household. As a result of increased interest on borrowing occasioned by the proposed standard, the study found, U.S. public companies would face $10.2 billion in higher annual costs. Commercial real estate would lose $0.6 billion in value in the Best Case scenario, and $14.8 billion in the Worst Case. The study was careful to note that the economic costs of other effects predicted in comment letters, such as higher rents, shortened lease terms, downward pressure on real estate values, increased administrative costs, and problems for users of financial statements resulting from obscured financial reporting were not included in these totals.


International Accounting Standards Board Financial Accounting Standards Board September 13, 2013 Page 10 Unintended Consequences The Boards have repeatedly stressed that sound accounting standards should accurately represent the underlying economics of a transaction, but never distort economic behavior. The aforementioned studies conclude that the proposed Leases standard will create massive distortions in economic behavior. Yet while the methodologies and conclusions of these studies may be tested, in the period since the studies were issued in 2011 and 2012 there is no evidence the Boards have undertaken any effort to do so. Nor, to our knowledge, have the Boards commissioned their own independent studies or otherwise sought to seriously evaluate whether the proposed standard will or will not occasion the significant economic disruptions that these studies forecast. In this respect, several commenters and presenters at roundtables have noted that the proposed standard would induce lessees to prefer shorter-term leases, or to elect to purchase real property in lieu of leasing it, in order to demonstrate stronger balance sheets. A shift to shorter lease terms, it has been noted, would result in the likely decrease of real estate values. Another consequence of shorter lease terms is that tenants could be expected to face higher lease payments. Finally, it has been observed that shorter leases will raise the cost of (or possibly make unavailable) the construction and permanent financing that lessors must obtain in order to successfully build and lease commercial and industrial real estate. We agree with these assessments. One of the major unintended consequences of the proposed lease accounting standards will be to alter the business fundamentals by shortening lease terms or eliminating altogether tenants' desire to lease. Tenants will have strong incentives to opt for shorter-term real estate leases in order both to reduce their reported liabilities, and to avoid the complexity of constantly estimating and re-estimating whether and when future real estate lease options will be exercised. They will also be incented to avoid real estate lease renewal options, and to negotiate leases with no contingent rent. Both of these eventualities would diminish the attractiveness of leasing from the tenant’s point of view. For some companies, the perpetual expense of information and ERP systems, consultants, and constant monitoring that would be required for real estate lease accounting will simply eliminate leasing as a viable alternative. Other impacts that commenters have highlighted include higher costs from lessees creating and implementing extensive information systems and accounting processes to track all leases in detail; hiring outside consultants to assist with prospective judgments about issues such as lease option exercise; and engaging in more frequent lease negotiations resulting from shorter-term leases. In this respect, Intel, URS and Chevron


International Accounting Standards Board Financial Accounting Standards Board September 13, 2013 Page 11 reported that complying with the new standard would increase accounting costs by $6 million, up to $10 million and more than $50 million, respectively. Majestic Realty Co. agrees with the many commenters who have observed that the proposal as it relates to real estate leasing would also deeply disturb the existing contractual relationships between real estate lessees and lenders. The very large amounts that would be required to be capitalized would immediately trigger the violation of many loan covenants. This would unfairly alter the bargained-for rights and responsibilities of banks and borrowers, provoking loan accelerations and giving banks a windfall option to refuse to adjust the existing covenants if they so chose. Alternatively, banks could demand new compensation for agreeing to revise the covenants. In most cases, at a minimum, companies' debt agreements would have to be renegotiated, at great (and wasteful) expense, to protect against these unintended consequences. Already, the mere consideration of the proposed Leases standard has changed the way companies’ loan agreements with commercial lenders are written, with many covenants expressly incorporating U.S. GAAP as it existed on the date of execution of the loan agreement. This is obviously a suboptimal work-around, since it deprives both borrower and lender of the benefit of adherence to current account standards in the future. In a 2011 interview with the Journal of Accountancy, FASB Chairman Seidman – in response to a question whether the Leases standard would be subjected to field testing –eschewed the idea, stating that to her “field-testing means a full-blown attempt to implement the standard. That’s not what I’m talking about.” Instead, the Chairman believed that going out in the field “to discuss a particular idea or proposal with constituents” would suffice. A “well-informed conversation will give us the input we need to know whether we’re on the right track,” she said. With respect, this falls far short of the due process that is required to confidently impose a new global standard on all public companies that will immediately result in the shifting of trillions of dollars onto balance sheets. The new standard will apply to potentially tens of thousands of lease contracts at a single reporting company. The unit of accounting under the latest proposal remains the individual contract level. Compliance with these extensive new requirements will entail significant new costs for both internal and external technical accounting resources, information systems, controls, and audit-related support. These risks, combined with the potential for substantial negative economic impacts and unintended consequences, require a “full-blown attempt” to observe and learn from experimental implementation of the proposals. Majestic Realty Co. strongly urges, in the interests of prudence and professional rigor, that the Boards conduct a thorough-going field test to move the Boards’ understanding of implementation costs, practicability, consistency of results, negative impacts, and


International Accounting Standards Board Financial Accounting Standards Board September 13, 2013 Page 13 unintended consequences from the realm of guesswork to objectivity. This work will help the Boards in your analysis and decision making, while identifying areas of weakness in the current proposal and suggesting potential changes in its requirements. Such field testing would also significantly advance the aims of the Boards to balance the goals of simplicity and accuracy. Were the field test to include analysts and users of financial statements such as Majestic Realty Co., it could provide the Boards with a basis for evaluating whether the proposed requirements will provide sufficient decision-useful information for users of financial statements, whether users of financial statements will continue to be able to easily find the information they need to make their preferred adjustments to the financial statements, and whether the benefits of the new information can justify the costs. III. Distortion of Financial Results Two important priorities of the Boards’ joint project on Leases are to reduce undue complexity in lease accounting, and to better serve the interests of users of financial statements. The proposed changes to lessor and lessee accounting seem aimed only indirectly at these objectives. Instead, the direct thrust of the proposed standard in the most recent Exposure Draft is simply to move all leases onto the balance sheet. This a priori determination is not designed to achieve the stated mission of FASB and IASB to create an accounting model that will faithfully represent all leasing transactions, including those involving commercial and industrial real estate. In economic reality, commercial and industrial real estate leases provide for contractually-determined rent payments that produce readily identifiable cash flows. Since the tenant does not acquire the benefits of ownership (except in the case of a “lease” that, under well-established principles concerning capital leases, merits classification as a purchase), and since in all events the land is never depreciated, the most objective, consistent, and readily understandable way to represent the substance of the transaction is to report the cash flow as a period expense. Such data are well understood by users of financial statements, including ourselves, and can easily be recast according to the users’ requirements. The Exposure Draft, in contrast, proposes to abandon financial reporting based on objective reality in favor of derived numbers. Instead of rent – a real number representing a known financial transaction – companies will report figures based on assumptions, judgments, and forecasts. Specifically, tenants in commercial and industrial real estate leases (together with their accountants and consultants) would have to guess


whether in the future they will have a “significant economic incentive” to exercise a renewal option or an early termination option. This can be no better than a guesstimate at best in the context of real estate leasing markets. Rather than introducing transparency and clarity to financial statements, this would make financial statements less comprehensible and less reliable. Not only will it lead to confusion among users of financial statements and widely varying reporting for similarly situated entities, but it will also open the door to potential manipulation. Moreover, even in the case of honest and well-intentioned guesses, companies would be exposed to criticism if their estimates prove incorrect. While the theory of determining the probability of exercise for a particular option is sound, and while for non-real estate leases it may be comprehensible, the practical implementation of this in the area of real estate leasing would be merely to codify uncertain fortune telling. Unlike other areas of accounting in which the unavoidable hazards of estimation are tolerated because of the undeniable usefulness of the estimates, in the case of commercial and industrial real estate lease options the product of such estimation is essentially useless. One important reason for this is that the likelihood of exercise of a non-marketable real estate lease option is as much a function of the lessee’s future space needs as it is of the future prices of rents, making estimation completely idiosyncratic, subjective, and unreliable. Companies negotiate options into their commercial real estate leases in order to obtain flexibility, precisely because of their own uncertainty about the future and their need to prepare for vastly different eventualities. It stands this reality on its head to then force them nonetheless to artificially calibrate an option exercise as if it is more or less likely to occur. Similarly, the tenant will have to apply its incremental borrowing rate, which is variable, to determine the present value of the future lease payments, unless the rate the landlord charges the tenant is not “readily determinable” to the tenant. This guarantees not only that the value will constantly fluctuate, but also that tenants with identical leases will report potentially materially different amounts on their financial statements. This would seriously undermine the Boards' objective of consistency of application. Moreover, these variations and inconsistencies will continually flow through not only the balance sheet but also the income statement, potentially obscuring the company’s results of operations and distorting the bottom line. It seems elementary that company earnings should not fluctuate with fair value adjustments to leased, rather than owned, real estate. Just as some lessees will value their leases based on option periods and others will not, some lessees will include all future rent in their calculation of the lease asset and liability, while others will not. That is because the Boards’ proposal sensibly provides that variable rents based on performance or usage should be excluded from the calculation of the lease liability. Instead, they would be recognized on the income statement as incurred. Since the value of the right-of-use asset is based on the amount of the lease liability, both the asset and the corresponding liability would be reduced by the amount of such variable rents. In the case of a lease providing for substantially all of the rent to be determined on the basis of performance or usage, with only a small fixed rental payment,


International Accounting Standards Board Financial Accounting Standards Board September 13, 2013 Page 14 the “asset” that appears on the balance sheet would therefore be tiny. A lease based entirely on such variable rents would not appear on the balance sheet at all. It is perfectly understandable that the Boards have proposed this approach to variable rents based on performance or usage, since forcing lessees to estimate such unknowable quantities would truly be guesswork. Far from demonstrating a flaw in the Boards’ proposed treatment of variable rents that are not based on an index or rate, this inconsistency demonstrates a flaw in the concept of what properly constitutes an “asset” and a “liability.” The inevitable discrepancies in lessees’ recognition of lease assets and liabilities will make corrupt the comparability of financial statements, making them less reliable and more opaque. Beyond the burden for users of financial statements resulting from obscured company cash flows and results, the risk is that the proposed standard could make it more difficult to assess the financial strength of a company. At Majestic Realty Co., we are particularly concerned about this as we rely upon the information in our current and prospective tenants’ financial statements to evaluate their existing lease expense. We recommend that the Boards move away from an approach that would distort the actual economics of real estate rental payments. Having gone through the elaborate exercise of attempting to model the economics in order to force commercial and industrial real estate leases into a pre-conceived conceptual framework, it should now be clear that the most perfect approximation for the rental payments is the contractual payments themselves. Use of the contractual rental payments on the income statement has a number of advantages. First, these are real (not derived, projected, or assumed) numbers. Second, it is not burdensome for companies and preparers of financial statements to produce them. Third, use of these data solves the problem of artificially modeling rental expense and so avoids distorting the financial statements in that way. Finally, use of contractual rental payments provides much greater transparency into a company’s actual results and financial condition. IV. Conclusion Two months ago, the American Accounting Association published a study that found the current approach to lessee accounting in U.S. GAAP, based on operating lease footnote disclosures, is effective. Specifically, the study found that this information is processed efficiently and effectively by users of financial statements, as evidenced by the market pricing of debt and equity securities of companies with operating lease obligations.


International Accounting Standards Board Financial Accounting Standards Board September 13, 2013 Page 15 The study observed that lease disclosures are strengthened by the fact that, unlike many other kinds of disclosures, “they are not subject to significant management judgment and estimation.” The tenant’s rent payments “are contractually specified.” As a result, from the point of view of users of financial statements, “[i]mputing lease obligations from operating lease disclosures requires only a simple present value technique that is taught in introductory accounting textbooks.” Since “all the cash flows in a lease are specified,” the study concluded, “and the valuation technique involves only simple discounting,” the current U.S. GAAP approach to lease accounting “offers the advantages of easily understandable, contractually specified disclosures that are readily analyzed using simple techniques.” As a major user of financial statements to evaluate the commercial and industrial real estate lease obligations of public companies, Majestic Realty Co. could not agree more. The results reported by this study comport exactly with our own experience. Against this backdrop of a standard that works reliably for users of financial statements, we appraise the proposal in the latest Exposure Draft and find it sorely wanting. The proposed standard would be expensive, complicated, and distortive. We are not alone in reaching this conclusion. On August 27, 2013, the FASB Investors Technical Advisory Committee concluded that the Exposure Draft is not an improvement over the current U.S. GAAP standard for leases. The proposed standard, the ITAC said, is too complex. Instead of pursuing a radical revision of all of lease accounting, the ITAC recommended improved disclosures. The important work of the FASB and IASB to review the current standards for lease accounting and provide greater clarity, transparency, and consistency of application requires that the Boards take heed of this evidence that, notwithstanding enormous effort, the proposal is unable to meet the Boards’ original stated objectives. At a minimum, the Boards should appreciate the fundamental differences between commercial and industrial real estate leases and other kinds of leases, and provide for real estate leases through enhanced footnote disclosure. There is solid precedent for this. Already, the proposal effectively excludes some real estate leases based on their short term, and other real estate leases based on their use of variable rents determined by performance or usage. In recognition of the inherent differences of other kinds of leases, the current proposal would also exclude leases of intangible assets, leases of natural resources (such as minerals, oil, and natural gas), and leases of biological assets. The maintenance of these exclusions is founded in the conviction that the nature of the underlying leased asset is relevant to its financial statement treatment.


International Accounting Standards Board Financial Accounting Standards Board September 13, 2013 Page 16 More closely tailoring the accounting treatment of commercial and industrial real estate leases to the substantive economics of these transactions would eliminate the many unintended negative consequences outlined above, and it would solve the problems in the proposal as it relates to real estate lease options and remeasuring. To fully implement this recommendation, the Boards should require enhanced disclosures surrounding a company's future real estate lease obligations, summaries of real estate lease option terms, and information concerning variable rents in order to provide financial statement users with more accurate, consistent and objective financial representations of real estate leases. This action would be consistent with the findings of the study reported by the American Accounting Association finding that disclosed information is processed by users of financial statements and investors just as effectively and efficiently as recognized items. Finally, we strongly urge the Boards to take seriously the requirements for genuine due process before unleashing such a sweeping change in long standing accounting standards on a planetary scale. The Boards should undertake a thorough cost-benefit analysis of the proposed standard, and schedule robust field tests to evaluate its workability and usefulness. The enormously broad scope of this proposal, and the potentially serious negative impacts on national economies that have already been identified by multiple studies, amply warrant such prudence. We are grateful for the opportunity to submit these comments, and look forward to participating in the upcoming Los Angeles roundtable. Sincerely,

Edward P. Roski, Jr. Chairman and CEO Majestic Realty Co.


Majestic Realty Co. 13191 Crossroads Parkway North City …eifrs.ifrs.org/eifrs/comment_letters/24/24_11230_EdwardPRoskiJr... · Majestic Realty Co. 13191 Crossroads Parkway ... market

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