Action Plan – iLeasePro – ASC 842 Lease Accounting Blog

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!

LEASE ACCOUNTING CHANGE EXAMPLE

iLease Management LLC monitors and reports on the progress of the proposed changes to lease accounting. The FASB and the IASB issued an Exposure Draft in 2010 which generated a significant amount of controversy among preparers and users of financial statements. The Boards continue to meet to evaluate the more contentious issues and are considering changes to the Boards’ original proposal, particularly in such areas as lease renewal options and contingent rents. Included is a simplified example of how we expect the current changes to impact the accounting process and reporting for a basic real estate lease. This example does not take into account many of the more complex and subjective areas of the original Exposure Draft dealing with subjects such as lease renewal options, contingent rents, residual value guarantees and term option penalties.

To illustrate the impact of the proposed new lease accounting model for lessees, consider the following example:

Assumptions

A four-year non-cancelable lease term: 48 months
Minimum monthly lease payment: $1,000
1. Assuming there are no defined lease options, contingent rental payments or residual value guarantee
2. Incremental borrowing rate: 7%

Calculated Amounts

Present Value (PV) of lease payments = $42,000

Total lease payments over the 48 month term = $48,000

Balance sheet analysis

Under current GAAP Accounting for an operating lease where rent is accounted for in the current period

Existing US GAAP
	At inception	End of Yr 1	End of Yr 2	End of Yr 3	End of Lease Term
No asset	$0	0	0	0	0
No liability	$0	0	0	0	0

Under the proposed guidelines, there is an increase in assets and liabilities.

Proposed Model
	At inception	End of Yr 1	End of Yr 2	End of Yr 3	End of Lease Term
Assets
Right To Use Asset	$42,000	31,500	21,000	10,500	0
Liabilities
Rent Payable	$42,000	32,600	22,450	11,600	0

Profit and loss statement expense analysis

Under the proposed model, the right to use asset is amortized to expense over the term of the lease and the rent payable liability decreases as rental payments are made.

	Year 1	Year 2	Year 3	Year 4
Existing US GAAP
Rental Expense	$12,000	12,000	12,000	12,000

Proposed model

Amortization of Right To Use Asset	$10,500	10,500	10,500	10,500
Interest Expense	$2,600	1,850	1,150	400
Proposed Expense	$13,100	12,350	11,650	10,900

Accounting entries under the proposed model would be as follows:

	Debit	Credit
Accounting by lessee – at inception

Right To Use Asset	$42,000
Rent Payable		$42,000

Accounting by lessee – year 1

Amortization Expense	$10,500
Right To Use Asset		$10,500

Interest Expense	$2,600
Rent Payable		$2,600

Rent Payable	$12,000
Cash		$12,000

In the profit and loss statement, rental expense under existing US GAAP becomes a combination of amortization and interest expense under the proposed model. Expense under the proposed model is higher in the earlier years of the term of the lease due to interest expense calculated using the effective interest method applied to a declining outstanding balance of rent payable.

In addition to the reporting changes to the balance sheet and P&L report identified above, firms should evaluate the impact to;

Current accounting processes
- Lease Accounting system/software
- Income tax impact
- Financial Ratios
  - Increase in EBITDA
  - Return on Assets
  - Debt-to-Equity
  - Interest Coverage
  - Operating Margins
  - Debt covenant compliance
  - Ability to secure financing
  - Integrity of lease information
  - Resources required

iLease Management LLC will continue to closely monitor and report on the decisions of the FASB/IASB Board meetings on the lease accounting changes.