a closer look at the revised lease accounting proposal--may 2013--(ey)
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PwC page 1 of 7 July 2011WL200387
Proposed overhaul of accounting for leases
a significant issue for the real estate and
construction industryAp pl ic ati on : A fin al sta nd ard is exp ected in the fir st half of 20 12 . The app li ca tion date is ye t to be
determined.
What is the issue?
On August 17 2010 the International Accounting
Standards Board and Financial AccountingStandards Board (the boards) issued exposure
draftLeases(ED). The ED outlines an accountingmodel that would significantly transform leaseaccounting and affect almost every business.
Under the proposals entities will need to recognise
most of their existing and new leases on the balancesheet.
The proposals require lessees and lessors to estimatethe lease term and contingent payments at the
beginning of the lease, then re-assess the estimatesthroughout the lease term. This activity will requiremore effort and judgement than under existing
standards.
The boards received over 781 comment letters inresponse to their ED (key themes are discussed in
the following pages). The boards have identifiedsome areas which they will focus their re-deliberations. The areas of focus include leasedefinition, lease term, lease payments, timing of
expense recognition. The boards originallyproposed a dual model for lessors. Following re-
deliberations, it has been determined that lessoraccounting is not broken. Therefore the boardshave tentatively decided that the new leasing
standard will not include proposals to changeexisting lessor accounting.
The boards are aiming to issue the final standard inH1 of 2012. A re-exposure or review draft is
expected in Q3 2011.
Note.In this document we consider the proposedchanges to accounting for leases in the exposure
draft and include tentative decisions made to date.Any conclusions noted here are subject to furtherinterpretation and assessment based on the final
standard. Talk to your usual PwC contact for latestupdates.
Why is this significant for the real estateindustry?
If adopted, the proposals will have pervasivebusiness and accounting impacts. In particular, the
impact on financial reporting could be substantial inthe real estate industry. For example:
expense recognition patterns willchange.Cash payments versus expense
recognition will further diverge, particularlyfor long leases. While cash payments remain
unchanged, the profit or loss will have front-loading of expense with higher expensesrecorded in earlier years. Managements
judgment concerning certain contingent rents,such as lease payments which are linked to
inflationary increases, may producesignificant income statement volatility;
all leases will generate a liability forlessees.Analysts and credit agencies areunderestimating the significance of theliability when adding back debt-like items
for operating leases. A material lease liabilitycould be added to the balance sheet for
significant capital items (such as real estate)
Real estate andconstruction
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PwC page 2 of 7 July 2011
or a large number of lease items (such as anumerous space-users) that occupy only a
small portion of a larger facility;
decision points and data needs willchange. Operating lease accounting as we
know it will change considerably. Structuringconsideration will change to focus on liability
and volatility reduction as opposed toobtaining operating lease treatment. Dataneeds for ongoing reporting will change
significantly;
lease-versus-buy decisions should berevisited.Without the desired accounting
treatment for operating leases, managementmay prefer to purchase assets rather thanenter into lease arrangements, such as small
ticket items. However, leasing may continueto be viable for a variety of business reasons in
the real estate industry, as the assets tend tobe large-ticket items and companies prefer notto own these types of assets to maintain
operating flexibility. Entities that occupy asmall portion of a larger facility (eg, tenant in
a retail mall) or expect to occupy a facility fora period substantially shorter than the usefullife of the asset (eg, three years for an office
building with a useful life of 50 years) mayfind leasing more appropriate. Lessors may
want to consider how these proposals might
affect their business strategies. IT systems and internal processes may
need updating.Manually tracking leaseportfolios in spreadsheets or pre-packagedsoftware may not easily accommodate the
proposals. Industry-wide neglect of leasingsoftware and systems may necessitateupgrades and enhancements.
What are the overarching proposals?
The key elements of the proposals and their effecton financial statements are as follows.
Lessee accounting
The proposal effectively eliminates off-balance sheetor operating lease accounting for most leases. All
assets classified as operating leases would bebrought onto the balance sheet, removing thedistinction between finance and operating leases.
The board is considering if leases of approximately12 months or less should continue being accounted
for as operating leases (as we currently know it).Many in the real estate industry have assumed thatleases will apply accounting similar to the current
guidance for finance leases; however, themeasurement of the right-of-use asset and lease
liability is different to existing finance leaseaccounting. Also, the balance sheet impact hasreceived the most attention but there are also
changes from operating leases to the timing of therecognition of expenses in the income statement to
be mindful of.The significant impacts of the proposals are listed
below.
A right-of-use asset (representing the right touse the leased item for the lease term) and an
obligation (representing the obligation to payrentals) would be recognised and carried atamortised cost, based on the present value of
payments over the term of the lease.
Following re-deliberations the lease termwould include optional renewal periods thathave a significant economic incentive. Duringre-deliberations, the boards tentatively
decided to raise the threshold of extensionoptions in the lease term to those that providea significant economic incentive. For
example, where an entity can exercise anoption toextend the lease, or not to exercisean option to terminate the lease. In practice,
this means that lease terms may be similar tothose determined under the existing
standards. However, determining whether arenewal option is expected to be exercised isnot dependent on management intent or past
practice; rather it is based on whether asignificant economic incentive exists at the
time of the assessment.
Under the ED, the use of an expectedoutcome approach to estimate lease
payments was proposed in order to measurethe initial value of the lease asset and liability.This approach would include consideration of
certain contingent amounts, such as rentslinked to variables such as the Consumer PriceIndex (CPI). However, in recent re-
deliberations, the boards have tentativelydecided that the estimate should only include
contingencies that are: i) based on a rate orindex; ii) are disguised as a fixed leasepayment; and iii) have residual value
guarantees which are expected to be paid.This would mean that estimated lease
payments will not be as subject to judgement
as originally proposed in the ED. Under the ED, lease renewals and contingent
rents would need to be continually reassessed
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PwC page 3 of 7 July 2011
by entities, and the related estimates adjustedas facts and circumstances change. However,
in recent re-deliberations, the boards havedecided that reassessment of the lease termshould be performed only under certain
circumstances. This would substantiallyreduce the time entities would need to invest
in reviewing estimates and updatingcorrelating numbers; it was a common issueraised by entities in response to the proposals.
Presentation and disclosure
Due to the significantly expanded use of estimatesand judgements in the proposals, disclosurerequirements will go well beyond those required
under current the leasing standard. Quantitativeand qualitative financial information that identifies
and explains the amounts recognised in financial
statements arising from lease contracts and adescription of how leases may affect the amount,
timing, and uncertainty of the entitys future cashflows would be required.
Specific disclosures would also be required, such asa description of an entity's leasing arrangements,
the existence and terms of optional renewal periodsand contingent rentals, and information aboutassumptions and judgements. In addition, any
restrictions imposed by lease arrangements, such asdividends, additional debt, and further leasing
should also be disclosed.
The following disclosures would also be required
under the proposals.
Information about the principal terms of anylease that has not yet commenced if the lease
creates significant rights and obligations (suchas pre-committed leases for which a lessee
commits to an arrangement prior to thecommencement of the lease period, wherecertain arrangements may be flexible. E.g.
Duration of lease period, rates, floor area.).
A reconciliation between the opening andclosing balances of right-of-use assets andobligations to pay rentals, disaggregated byclass of underlying asset.
A narrative disclosure of significantassumptions and judgements relating torenewal options, contingent cash flows and
the discount rate used.
A maturity analysis of the gross obligation topay rentals showing: (a) undiscounted cashflows on an annual basis for the first five yearsand a total of the amounts for the remaining
years; and (b) amounts attributable to theminimum amounts specified in the lease andthe amounts recognised in the balance sheet.
Additional disclosures would apply if: (a) thesimplified option for short-term leases is
elected; (b) significant subleases exist; or (c)there is a sale-leaseback transaction.
For some entities the proposed disclosure
requirements would involve significant datagathering (and maintenance) exercise. In practice -
and across the real estate industry as a whole - weexpect that meeting these disclosure requirementswould require a significant amount of time and
energy.
How would typical terms & conditions in the real estate and construction industry
be affected?
Terms Example Existing accounting New accountingPotential impact on the
real estate industry
Co-tenancy
clauses
There are various types of co-
tenancy clauses. One exampleis for key tenants whom
other tenants believe are
critical to the successfuloperation of the location. If a
key tenant departs, a co-
tenancy clause provides the
tenant with some form ofprotection in the form of
reduced rent to compensate
for loss of traffic.
Reflect any reductions in the
period they occur but do notproject them in considering
minimum lease payments.
Same as existing
accounting.
Minimal impact on business
strategies
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PwC page 4 of 7 July 2011
Terms Example Existing accounting New accounting
Potential impact on the
real estate industry
CPI escalations Tenant of an office unit
within a larger commercialbuilding has a rent escalation
each anniversary date based
on the change in thepublished Consumer Price
Index.
Treated as contingent rent
which is not included inminimum lease payments
used for straight line rent.
Instead, the expense isrecognised in each annual
period based on actual increase
in that period.
The new standard would
require the office tenant toinclude CPI escalations
using the spot rate to
measure its lease liabilityunder these provisions for
whatever lease term is
utilised (including potential
extension options) andinclude them in the
calculations.
CPI escalation provision
features will no longer haveadvantageous accounting for
lessees. We expect that the
use of such provisions may bereduced in practice if for no
other reason than to reduce
complexity by moving to a
fixed rent strategy. Clauseswith fixed rental increases
may be included in
agreements upfront.
Free rent
periods
Retail tenant given six-month
free rent period in connection
with 10-year lease.
Current lease model would
apply a straight line rent
method whereby expense isreflected based on a
mathematical average of theaggregate minimum lease
payments, spanning theduration of the lease term. The
model does not compensate for
the economic impacts of the
timing of payment.
The new model would have
no cash out-flows in the
present value calculation forthe first six months. As a
result, initially the right ofuse asset and lease
obligation would be lower.The obligation would
increase over the free rent
period as the obligation is
remeasured using aconstant effective yield withinterest being added to the
balance during the free rentperiod (i.e. like a negative
amortising loan).
The impact is likely to be
largely economic and unlikely
to affect business practices inthis area.
Lease
allowance
Property owner pays tenant
$1 million for part or all ofthe improvements to the
leased property.
If the tenant allowance is for
improvements to tenant assets,the accounting is the same as
described under lease
inducement below. If the
tenant allowance is forimprovements to property
owner assets, the payment is
treated as a reimbursement for
the cost of a lessor asset withno additional accounting over
the lease term.
The accounting for a tenant
allowance forimprovements that are
considered to be tenant
assets is the same as
described under leaseinducement below. There
is no change from existing
accounting for
improvements considered tobe property owner assets.
Minimum impact on business
strategies
Lease
inducement
Property owner pays tenant
$1 million to enter into a
lease that may be used for any
purpose.
Treated as negative rent
payment and reduction in
minimum lease payments to be
reflected using straight-linemethod over lease term.
Treated as reduction in
lease obligation and,
therefore, the asset at
inception. As a result, theamortisation (generally
straight-line method) over
the lease term (including
potential extension options)would be lower.
Minimum impact on business
strategies. For accounting
purposes, there is no impact if
the lease term is the same.However, if extension options
are included, then the
amortization period may be
different.
Percentage rent Retail tenant pays additional
rent of 4% of annual sales at
the location in excess of $10million.
Treated as contingent rent
which is not included in
minimum lease paymentsused for straight-line rent
purpose; rather the expense is
recognised based on actualsales when it becomes probable
that annual sales will exceed
$10 million.
The boards tentatively
decided that variable rents
based on performance orusage are excluded from the
estimate of lease payments.
As a result, percentage rentmay continue to be treated
the same as under existing
rules.
Minimum impact on business
strategies.
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PwC page 5 of 7 July 2011
Terms Example Existing accounting New accounting
Potential impact on the
real estate industry
Prepaid rent or
uneven rent
Lessee prepays a significant
amount of rent at theinception of the lease.
Rent recognised over the term
of the lease on a straight-linebasis.
New model would recognise
an asset and a liability forthe payments. Since the
prepayment is made at
inception, it would not havea present value discount.
The right-of-use asset would
amortise on a straight-line
basis. Interest on theobligation would be
reduced or eliminated
(depending on whether
partially prepaid or fullyprepaid).
Minimum impact on business
strategies.
Security deposit At the beginning of the leaseterm, tenant pays property
owner $1 million, which isapproximately two months of
rent due under the leaseagreement. The amount
protects the property owner
from a default by the tenant
or damage to the leasedproperty caused by thetenant, which is refundable if
neither occurs.
Treated as a liability by theproperty owner and as an asset
by the tenant until returned tothe tenant or used by the
property owner in the event ofa default or damage to the
leased property.
Same as existingaccounting.
Minimum impact on businessstrategies.
Tenant
improvements
At the beginning of the lease
term, tenant pays to improve
the space.
Treated as a separate asset
amortised over the lesser of the
life of the improvement or the
assumed term of the lease.
Same as existing
accounting. However, under
the proposed model, the
lease term may now belonger if option periods are
included. There should be
consistent assumptions
between the amortisationperiod and lease term.
Minimum impact on business
strategies.
Termination
rights
A retail tenant is uncertain
about the potential viabilityof a location. They sign a 10-
year lease with the right to
terminate the lease after twoyears.
Frequently these are
considered 10-year leasesbecause of the penalties from
having to walk away from the
tenant improvements.
Lease term probably similar
to current practice. A similarlease could be structured as
a two-year lease with a right
to extend for eight years.The new model will
evaluate the expected term
as either two years or 10
years based on theprobability of the lease
running for those periods.
Minimum impact on business
strategies.
Summary of comments on the proposals
Over 780 comment letters were received in response
to the boards proposed changes to leaseaccounting. There are a number of recurring themes
in the comment letters and roundtable discussions,across all industries. While a majority of therespondents are supportive of the need for the
project in general, especially as it relates to lesseeaccounting, most respondents have significantconcerns about many aspects of the proposals
contained in the ED, and strongly encourage theboards to take the time necessary to produce a
standard that is both high quality and operational.
Some of the common points expressed to the boardsare shared below.
Lessee accounting.Many respondentssupported the right-of-use model for lessees,at least with respect to the balance sheetimplications for simple leases.
Lessor accounting.Many respondentsindicated they did not believe the currentlessor accounting model was fundamentally
broken. Lease term.Almostall respondentsdisagreed with the definition of lease. The
boards revised the definition of lease term tobe the non-cancellable lease term taking into
consideration significant economic incentivesfor renewal terms.
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PwC page 6 of 7 July 2011
Lease payments.Most respondents werecritical of a probability-weighted approach;
the boards have since revised the approach touse a more appropriate best estimate
approach. Some respondents also believe thatcertain types of contingencies (usage,performance, or index-based) should be
treated differently depending on whether thevariable lease payment is within
managements discretion.
Expense recognition for lessees.Manyrespondents questioned the usefulness of this
model. This model results in a recognitionpattern for the lessee that changes theexpense recognition pattern of operating
leases from rental expense to a combination ofamortisation and interest expense. The boards
recognised that there are two different types
of leases: financing and other-than-financing. Financing leases will continue to
recognise amortisation and interest expense;whereas other-than-financing leases willcontinue to have straight line expense
recognition.
Leases versus service contracts.Manyrespondents (from both the lessee and lessor)
had concerns about accounting for anembedded lease in a multiple-element
arrangement in which the vendor can replace
the underlying asset or there is no specificasset identified in the contract (eg, leasing of
commercial real estate units with a servicescheduled service maintenance contracts).Multiple-element contracts that include a
lease and a service arrangement are asignificant concern to many. Many
respondents believe the standard shouldspecifically exclude service and executorycosts from lease payments rather than try to
link to the definition of a distinct serviceunder the revenue recognition Exposure
Draft. The boards continue to re-deliberatethis point.
Reassessment of lease terms andconditions.Many respondents raisedconcerns about the operationality andcost/benefit of this approach. These
respondents indicated that an annualreassessment may be appropriate while others
suggested a trigger-based reassessment.
Disclosure.Most respondents supported theoverall disclosure objectives, but believe that
preparers should be allowed to exercisejudgment in determining the volume ofdisclosures and financial statement
presentation.
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PwC page 7 of 7 July 2011
Is management ready for the changes?
PwC performed an impact survey to understand the reactions and perceptions of entities with respect to theproposed overhaul of lease accounting. The survey was conducted in cooperation with the Rotterdam School
of Management, Erasmus University. Over eight countries across over fourteen industries participated in thesurvey.
Highlights from the survey include:
The majority of respondents (74%) are unaware of the negative impact on net earnings in the firstyears after transition
The majority of respondents said they do not currently have or only to a limited extent have thenecessary information and data (68%), resources (74%), process (78%) and IT systems (76%) in placeto implement the proposals
Nearly half of respondents are unable to assess to what extent changes are needed to business models,business and financial processes, IT systems, reporting and closing processes, internal controls,performance measurement systems and budgeting and tax planning strategies
40% of respondents will not continue leasing real estate property in the same way as today. 22%expect to move to shorter leases. For other leases, approximately half of respondents will not continue
leasing the same way as today.
What should companies be doing now?
Inventory existing leases and perform an assessment to determine the impacts of the proposedstandard to your company.
Evaluate existing IT systems and hold discussions with IT providers to assess the systems currentcapabilities, and whether upgrades are both necessary and available.
Consider the impacts of the new rules upon major company initiatives, such as systems andcompensation plans.
Begin to assess what data will need to be collected and analysed prior to adopting the standard, toallow for a comparative presentation.
Consider the impacts on lease versus buy strategies. Establish a training and communication plan with employees and key stakeholders.Online lease accounting survey
An online survey is now available for entities to use across all industries. Through this survey, clients will beable to gain high level insight into the potential impacts of the proposed changes to lease accounting on their
organisation and its readiness for the implementation of the new standards.
Entities can access the survey through the PwC website www.au.pwc.com/leasediagnostic
Impact assessment tool
In addition to the survey, an impact assessment tool has been developed to perform a more detailedassessment of the new leasing requirements. The objective is to provide a quantitative and qualitativeassessment of the impact on key financial metrics and provides comparison to the existing leases approachover a specified timeframe.
Entities should contact their usual PwC representative to use the impact assessment tool.