A Closer Look at the Revised Lease Accounting Proposal--May 2013--(EY)

5/26/2018 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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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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Terms Example Existing accounting New accounting

Potential impact on the


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.


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.


strategies.


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Terms Example Existing accounting New accounting

Potential impact on the


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).


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.


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.


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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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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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.

Documents

A Closer Look at the Revised Lease Accounting Proposal--May 2013--(EY)