The lease-accounting rule changes proposed this past summer bythe International Accounting Standards Board and the US FinancialAccounting Standards Board have been called "long overdue" as wellas "drastic" and a potential "burden." If and when they take effectin 2012 or later, these rule changes-which cover equipment as wellas commercial space-may impact not only corporate balance sheets,but also the ways in which lessees think about leasing. Experts inboth accounting and real estate services are advising their clientsto be ready when the new FASB/IASB standards become reality.

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"Companies that use leasing should start thinking today abouthow this proposal could affect their financial statements, andshould consider the need to make changes to lease structuring,performance metrics, debt covenants and systems," said Joel Osnoss,global IFRS leader, clients & markets, at Deloitte ToucheTohmatsu Ltd., in a statement. "Education of key stakeholders willalso be necessary."

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Howard Roth, global and Americas real estate leader at Ernst& Young, said in a commentary for GlobeSt.com that the proposedrule changes "may lead to an overhaul of lease accounting."Deloitte notes that if the exposure draft released August 17 by theFASB and IASB reflects the final rule, "Operating leases may soonbe a thing of the past."

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Whatever headaches the new standard means for lessees andlessors, though, it could represent a boon for other interestedparties. "Our proposals would result

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in better and more complete financial reporting informationabout lease contracts being available to investors and others,"said Sir David Tweedie, chairman of the IASB, in a statement.Osnoss' colleague, global IFRS leader Veronica Poole, calls the ED"a long-overdue reality check, which will mean greater accountingtransparency for listed companies."

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The lease accounting standard proposed by the FASB and IASBwould eliminate

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the two current classifications: operating or capital leases.Operating leases are recorded as an expense in the income statementover the life of the lease, but generally do not appear on thebalance sheet, capital leases are recorded as assets on balancesheets, and then depreciated as an expense item in the incomestatement. The former gives the lessee only the right to use theproperty, while with the latter, the lessee assumes some of therisks and benefits of ownership.

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A lease is considered a capital lease under the FASB's FAS 13 ifit meets one of the following four criteria: it conveys ownershipto the lessee at the end of the lease term, the lessee has anoption to purchase the asset at a bargain price at the end of theterm, the term of the lease is 75% or more of the economic life ofthe asset, or the present value of the rents, using the lessee'sincremental borrowing rate, is 90% or more of the asset's fairmarket value. FAS 13 has generally required such a "bright line"classification of leases over its 34-year history.

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In place of these two treatments would be what the two boardscall "a consistent approach" to lease accounting for both lesseesand lessors, one that puts all leases on balance sheets. This"right of use" model, according to law firm Seyfarth Shaw, assumesthat each lease creates both an asset (the lessee's right to usethe leased asset) and a liability (the future rental paymentobligations).

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Or as Bob O'Brien, Deloittes US head of real estate, puts it,"They will have to put an asset on the books for the right to usespace over the lease term, plus any renewal options that are likelyto be exercised. Then they're going to have to put an offsettingobligation on the books as well as for the liability associatedwith the right to use space." O'Brien notes that this represents "adrastic change in terms of the accounting impact of leases."

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E&Y says landlords that operate under US GAAP will berequired to adopt one of two models for each lease: the"performance obligation approach," whereby the landlordrecords-along with the investment property-a lease receivable andan equivalent liability representing the lessee's right to use theunderlying property, or the "partial derecognition approach," underwhich the landlord must split its investment property between alease-receivable asset and the property's residual value. Unlessthe landlord retains the risks and benefits associated with theleased asset, it will have to identify the part of the investmentproperty that it no longer controls, and "derecognize" it from thebalance sheet.

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The current lease accounting model under FAS 13 has long come infor criticism. An article by Seyfarth Shaw's retail industry teamnotes that critics of the current standard maintain that "operatingleases, in fact, give rise to an asset and a liability that shouldbe disclosed on a company's balance sheet."

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By failing to do so, critics say, the current standard produces"a lack of transparency for users of financial statements thatrequire a complete understanding of a company's leasingactivities," and reduces the comparability of financial statementsbetween companies that account for their leases differently. These"off-balance sheet" operating lease obligations, Seyfarth says,translate to "significant fixed and contingent liabilities forcompanies," which have been estimated in the $1- trillion to $2-trillion range.

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The Securities and Exchange Commission has estimated that thechanges would prompt public companies to put over $1 trillion inassets and liabilities on their financial statements whensubmitting their lO-Q and 10- K filings to the SEC. Real estateservices firm Cassidy Turley says the proposed modifications willresult in changes in the timing and classification of expenses oncorporations' income statements, "which will impact key financialmetrics such as debt-to-capitalization ratio, EBITDA, interestcoverage and other metrics,"

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For commercial real estate, the implications of the newstandards are considerable. Among them are a possible shift toshorter-term leases as tenants seek to minimize the impact on theirbalance sheets and income statements. This in turn could increaseuncertainty around lease cash flows for owners and therefore "couldadversely affect the valuation of real estate for investors due toincreased roll-over risk," Roth says. Lessees with access tocapital may opt to buy their real estate rather than lease it.

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However, O'Brien isn't so sure that either change in tenantbehavior will actually come to pass. "We've had some informalconversations with a number of lessees, trying to get a sense ofwhether they're going to look at things differently," he tellsDistressed Assets Investor. Asked whether they'd lean towardshort-term leases, "the vast majority of lessees have said no. Theeconomics around short term leases, including what they wouldexpect to be higher costs around those leases and in some respectsreduced flexibility, outweigh the accounting." Those that mightconsider it are lessees "that are already financiallychallenged."

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On the question of leasing space versus buying it, "We arestarting to get indications that some will more seriously considerthe buy component, particularly triple-net lessees that are usingan entire property," O'Brien says. "A big-box retailer would be agreat example. Not everybody's going to buy the real estate, but wethink some lessees out there will be more likely to."

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More than lessee behavioral patterns stand to be affected by thenew accounting standards, though. Because lessees will now berecording an interest and amortization expense rather than a rentexpense, "any financial performance measurements that are based offnet income or earnings measures will be impacted," says Roth. Thatmeans, he explains, that EBITDA will improve, but covenants such asinterest coverage ratios could be adversely impacted, andconsideration will have to be given to other contracts that utilizeearnings measures, such as compensation agreements.

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Lessees and lessors operating under the performance obligationmodel will be required to gross up their balance sheets by thepresent value of the expected lease cash flows over the term of thelease. As a result, Seyfarth says, "debt covenants in financeagreements may be violated or triggered due to material changes inapplicable financial ratios." Heavily leveraged retailers, forexample, could become technically insolvent or worse.

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Given the possible impact on debt covenants, Roth says companiesmay need to negotiate amendments to lease agreements to considerthe new leasing model. "Companies may be hesitant to approachlenders with such a request in this uncertain credit environment,"he says.

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This new leasing model will require "significant assumptions" onthe part of lessees and lessors, Roth says, including theprobability of exercising extension options and contingent rentals.They will need to determine what is the longest term that is morelikely than not to occur for a given lease. Companies will berequired to develop processes and controls for identifying theseassumptions, leading to what Cassidy Turley calls "anadministrative burden."

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"The systems requirements shouldn't be underestimated," warnsO'Brien. "The projections you're required to do to anticipate thelease payments you'll be making over the term of the lease, andaccounting for those lease payments, are not insignificant,particularly for a retailer that has 800 or 8,000 locations."

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Given the ramifications of the new standards, and the likelihoodthat the FASB and lASB will enact them pretty much as presented inthe ED, companies such as E&Y are urging their real estateclients to prepare now. For its part, Seyfarth spells out thesepreparations, starting with an evaluation of the ED and the newlease accounting rules.

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The law firm also recommends clients monitor the comments andreview the final standard when it's issued, probably sometime in2011.

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Lessees and lessors alike should also measure the likelyreporting effect across their leasing platform and the potentialimpact on the balance sheet, Seyfarth says. The firm furtherrecommends that clients review the effect of new reportingrequirements on existing legal documentation related to their debtobligations and adverse effects on their companies' valuation andcredit ratings.

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The internal review, technology and process changes required bythe new rules need to be budgeted and planned for, Seyfarth says.That will mean educating the appropriate internal groupsresponsible for assessment, measurement and reporting as well asdetermining who will make the "difficult" calls about certaindecisions such as the most likely lease term and estimates of grosssales for percentage rent purposes. Finally, the lessee shouldreassess its leasing program and requirements "to minimize theimpact of the new standard."

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The FASB and lASB are accepting comment letters on the EDthrough Dec. 15, they will then begin redeliberations uponconclusion of the comment period. The two boards plan to undertakevarious outreach activities during the comment period. They intendto issue a final standard in 2011, the effective date of the newrules has yet to be determined. On the horizon is another FASBproposal, similar to the lASB's lAS 40, which would requirerecording investment property at fair value. An ED has not yet beenissued for this accounting standard change, but O'Brien and otherssay the proposal is being watched closely.


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