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May 11 2011

Action Plan for Lease Accounting Changes

As we have been discussing for a number of weeks, there are major changes that are being proposed in the accounting for leases for both lessees and lessors, with the major emphasis initially being directed to the lessee community. The result of these changes will be the elimination of the operating lease form of accounting, except for possibly shorter term leases of less than twelve months. In its place will be an accounting standard that would require that all lease obligations be reflected on the balance sheet with an offsetting asset for the right to use the leased space. Although the release of the final standard has been delayed until latter half of 2011, we believe that it is extremely important for those organizations that will be impacted by this new accounting to develop an Action Plan to monitor and assess the impact of these proposed changes.

Here are the key steps that we believe are necessary in order to develop a meaningful Action Plan for Lease Accounting Changes:

  • Ensure that all relevant internal parties are involved in the evaluation. In addition to the department that has primarily responsible for leasing, operating management may need to be involved in the assessment of renewal options and percentage rents and the finance function must be involved in the determination of any CPI provisions in the leases and the incremental borrowing rate to be utilized in the calculations.
  • Ensure that all legal documents supporting lease agreements are collected in one central location(s) and summarize the key information from the leases as follows:
    • Lease terms and related rental amounts
    • Renewal option terms and related rental amounts
    • Any contingent rentals provisions
    • Any percentage rental provisions
    • Residual value guarantee or termination penalty provisions
    • Service elements contained in leases
  • Assign responsibility for monitoring changes to the original proposal as it goes through the deliberation process. As concerns have been raised about the complexity and subjectivity of the original proposal, the FASB and the ISB have tentatively agreed to make changes to the original proposal in certain areas such as renewal options and percentage rents. These changes will help to alleviate some of the objections that have been raised but there is still a substantial element of uncertainty involved. It is critical that these changes be monitored and incorporated into the overall assessment of the proposed standard.
  • Understanding that the tax accounting for lease payment will not change and therefore there will be temporary differences between GAAP and Tax accounting that will result in additional deferred tax impacts. The finance function should be actively involved in assessing these implications and any tax planning strategies that may be undertaken.

Although the economics and cash flow of leasing decisions will not change, the entire organization should be aware of the material financial implications that may result from this accounting change. Profit and loss expense charges will accelerate as a result of this proposal. Some estimates have indicated that first year expense charges for a ten year lease will increase by approximately 20%. Additionally, the standard as proposed would require recognition and measurement of all leases outstanding as of the date of adoption using a retrospective approach. Therefore, there will be a significant impact immediately upon adoption. Leasing decisions made currently should take this into account.

  • Shorter term leases would result in a less significant negative financial impact, however, is this appropriate from a business perspective?
  • Should renewal options and percentage rents be eliminated from future leases?
  • How will tenant improvement allowances be impacted?
  • Is it time to reevaluate lease versus buy conclusions that might have been made in the past?

There will be a significant increase in assets and liabilities as a result of the adoption of the proposed standard. Loan covenants and other legal documents that may be impacted by these significant financial changes should be reviewed to determine the implications on financial covenants and ratios such as debt to equity and interest rate coverage.

There is a final thought that we believe is very important to consider. Do not think of this process simply in terms of complying with the new accounting standard. Use this opportunity to evaluate the entire leasing business process and the effectiveness of the procedures and controls surrounding that process. We believe that this is an area that has not received the proper attention in the past.

  • Have the significant terms of leases been summarized and captured in a system that allows the information to be readily obtained and evaluated?
  • Has there been manpower waste and redundancy in the past that should be eliminated?

There is now an opportunity to quantify the value of improved operational practices in the entire leasing process.

  • What about IT systems surrounding the leasing process?
  • Do they exist?
  • Are they adequate to meet the challenges that are presented by the new standard?
  • Remember that the financial implication of each new lease must be evaluated upon execution and reevaluated if there is a significant change in assumptions. Is this an opportunity to build an improved lease management process that will meet both the business and financial (both accounting and tax) needs of the organization?

    There has been no formal decision made about the effective date of the new standard but speculation has centered around 2013. Although this may seem like a significant time span, the effort needed to interpret the requirements as they pertain to each individual organization and complete the evaluation of the lease portfolio will be substantial.

    Now is the time to get started on this project!