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Buried in the middle of a speech he was giving on international accounting standards in Singapore at the end of May, Hans Hoogervorst, chairman of the London-based International Accounting Standards Board, dropped this bombshell about the revamped lease accounting standard that the organization and its US counterpart, the Financial Accounting Standards Board, have been working on for years.

“I will not bore you with the details, but more work needs to be done. In the next couple of months we should be able to finalize our work.”

Yes. After eight years and at least one reset in which the boards reissued their exposure draft, it appears IASB and FASB are getting ready to finalize a converged standard for lease accounting.

Or perhaps not. Certainly the industry has heard this before. For the record, Hoogervorst is referring to the exposure draft issued in May 2013, although the industry could be forgiven for having lost track.

The industry could also be forgiven for dismissing Hoogervorst's comment. Indeed, the accounting industry press that covered his comments focused more on the results of an internal study Hoogervorst also discussed, which found that the lease standard will ultimately only “significantly” affect 10% of listed global companies.

But what if the standard is actually almost here? Without a doubt real estate companies affected by the change that haven't done even the preliminary groundwork will have to do some fast recalibrating.

A Deloitte survey earlier this year indicates that many real estate executives expect the new standard to have significant financial reporting effects: 58% expect a significant impact on their balance sheets and 53% on disclosures.

Nearly half of executives foresaw an effect on financial ratios, significantly on debt to equity (71%) and return on assets (52%).

It is not as though companies are unaware of the overwhelming impact the standard poses to their balance sheets.

“When the boards first said they would start working on this way back when, everyone in the industry was eager for information about how to comply and what it would mean for their operations,” says Jonathan Keefe, managing director of Cassidy Turley in Boston. “But then came delay after delay, and then all the reports about how this and that would change.” In short, he says, the industry had other things to worry about. “People can only prepare for the same storm for so long.”

Assuming the standard is indeed ready to be unveiled, companies will be caught short in two ways, as Keefe sees it. One is the nuts-and-bolts of the compliance and the larger tech support that will be required. This will be painful but ultimately solvable, especially if enough resources are thrown at the problem in short order.

The second area is more comprehensive and will require a broader tool set to address—and that is the human judgments that will be required in applying the rules, whatever they may be.

For even after the rules are set, many decisions will still have to be on a case-by-case basis by managers on the ground, Keefe says. “The bigger problem for companies will be, 'how do I interpret this stuff?' How will they come up with a repeatable set of processes that will yield the same answer again and again?”

At the same time, Keefe says, companies will have to grapple with keeping their competitive plans or strategies from being made public because of this accounting change. “Companies may find they are divulging competitive strategies far in advance of when they normally would be because of this standard. When they file their financials when the standard is in effect, a competitor will be able to see that company XYZ has doubled down its investment in a certain geography and thus gets a heads-up that its competitor is focusing on that area.”

Bring In the Experts

Some—perhaps much—of the work to prepare for the standard will be handed off to CPAs, attorneys and business strategists to address, says Emre Carr, principal in Berkeley Research Group's Washington, DC office.

“Real estate companies will have to review their existing covenants and contracts and figure out if renegotiations will be necessary, and include flexibility in the new ones that they are entering until the changes are effective,” he warns. “Companies and their investors will have to rethink common rules of thumb, such as performance metrics, that involve earnings, because the rule change will affect earnings—more so for fast-growing real estate firms than mature ones.”

As beneficial as it would be to get a leg up on the work, unfortunately only so much can be done without a definitive standard in place, says Andy Corsini, national audit leader for KPMG's building, construction and real estate practice in the Chicago office. “Given the various changes and delays, many companies, including real estate firms, have decided to wait for a final standard before they begin to evaluate the impact on their business,” he says.

For some companies, this makes sense. Corsini's best guess is that, based on current exposure draft, it is likely to result in more effort for lessees of real estate, with some incremental effort for lessors of real estate. “Assuming the final standard is based on the board's current thinking, the standard will likely not have a significant economic impact for lessors of real estate.”

However, he is hardly betting his license on the matter.

“It is difficult to say what the final standard will look like,” Corsini says. “Companies should continue to evaluate the changes in the project and the impacts the new accounting requirements will have on their business and develop a plan to prepare for and deal with those impacts that involve operating, finance and accounting functions.”

What We Know

Unfortunately what we know about the standard, still in progress, is a moving target and the range of scenarios for which a company must prepare is frighteningly wide.

FASB and IASB have been working on it since 2006. The reason for the push to change was that huge off-balance sheet leases muddy the picture of a company's true financial obligations. For this reason, Carr believes the rule change, on balance, will be a welcome development for the greater good. The one point of consensus has been that such leases must be on companies' balance sheets. So this is what we know about the standard: companies will be required to recognize on their balance sheets the assets and liabilities resulting from all leases of more than 12 months, based on the present value of the lease payments. From a financial perspective, the change will be stark—no more off-balance sheet financing through leasing activities.

What We Don't Know

It's the “how” that has been the sticking point.

IASB and FASB proposed dividing leases into Type A and Type B categories with their own accounting treatment.

Type A leases, which would include mainly equipment and vehicles, would be accounted for by an amortization of the asset based on its useful life or the lease term.

Type B leases, including buildings or land, would be accounted for by expense recognition similar to today's operating leases.

But the two have not been able to form a consensus on how to implement this approach or even if this approach is best, and a March 2014 meeting further clouded the issue. Behind the scenes the uncertainty appears to be even greater than the dry language of the competing press releases.

In January of this year, for example, the Wall Street Journal reported that the two boards had discussed scaling back their efforts for lessor accounting—that is, for companies that lease assets such as airplanes or photocopiers to other firms.

Scott Muir, a FASB staff member, told the Journal that user comments had led FASB to conclude that the cost of making changes to lessor accounting would outweigh the benefits and significant changes may harm their analyses.

In another article in the Journal , FASB Chairman Russell Golden acknowledged his doubts about the dual approach, as the onus would be on the company's management and its selective judgment in deciding whether a lease qualified as Type A or Type B.

Hoogersvorst, as well, has told reporters that the majority of investors would prefer the single measurement model. Companies certainly lean to that model because it can make operating incomes look better, in certain cases.

The rule would also require companies to reassess their lease assumptions on an ongoing basis, which could prove costly and time-consuming, rule makers said in comments during an annual Financial Executives International conference.

There has even been talk of FASB and IASB dismissing the more complex parts of the proposal and settling for minor tweaks.

Without a doubt, in some quarters of the commercial real estate industry, that is the preferred approach. CoreNet Global members, during the comment period, urged FASB to follow the recommendation of its Investor Advisory Committee (one of the more inglorious moments of the lease standard-setting process came when FASB's own advisory committee said the current proposal was no good and should be junked).

“Real estate is a major driver of economic activity, both in the United States and around the world,” stated the letter, which was signed by Angela Cain, CEO of CoreNet. “At minimum, this proposed new standard will only serve to hinder positive global economic activity at a time when we are beginning to see some positive economic momentum.”

CoreNet's objections focused on the following about the proposed changes:

• They do not accurately reflect the economics of real estate and equipment lease transactions.

• They will have a negative material effect on provisions that companies will desire within leases, such as the length of lease terms and desire for lease options.

• Related Party Leases—one of the suggested provisions—are not currently tracked, and tracking this will add work at the subsidiary financial statement level.

• Implementation will be hard and take years as most companies have decentralized leasing processes.

• The proposed changes will cause significant duplication of records currently required for existing tax, bankruptcy and accounting state legal requirements.

• Most companies will have to install new systems or upgrade existing ones to comply with proposed standards.

The Tech Piece

CoreNet's latter point, about the cost of implementing new technology, was reflected in a Deloitte survey earlier this year that found in the case of real estate lessees, confidence in their preparations for the new standard has actually fallen in the past two years, with only 1% “extremely” or “very” prepared to comply in 2013, down from 9% in 2011.

The tech piece is what appears to have companies, especially larger ones, the most concerned, with 62% of large firms stating that the adequacy of their IT systems would present a significant compliance challenge, versus just 49% of smaller ones. Also, 55% of large companies saw creating a complete electronic inventory of real estate leases as a major challenge, versus only 33% of small firms.

“Large companies typically hold big, complex lease portfolios, which are going to present a significant data issue,” said David Swanson, senior manager, Deloitte Transactions and Business Analytics LLP. He noted that roughly 40% of surveyed companies are planning to employ a temporary IT solution during implementation, “but there remains a lot of work to do on upgrades or installing new systems for the long-term.”

Perhaps companies would be willing to swallow the IT costs without much complaint, if they felt the standard would be beneficial to their operations in the long run. But, as CoreNet's comment letter indicated, few, if anyone, in the industry does think that.

A separate report released earlier this month by Cresa and Financial Executives Research Foundation found that 85% of surveyed companies—a group that included both lessors and lessees—expect the proposed changes to have a negative impact on the economics of their business.

Says George Boyadjis, corporate services director with Cresa Minneapolis, and former board chair for both FEI and FERF: “Company metrics will be impacted, including EBITDA, net income and cash flows, which in turn will affect loan covenant compliance, credit ratings, and other measures of financial strength. Many companies will report net income results which will be worse under the new rules than under the current rules.”

Maybe it wasn't that the industry wasn't paying attention to Hoogervorst's speech earlier this year. Maybe it was just engaging in a bit of hopeful denial.

Instant Insights /

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