Lease Accounting Changes For Dummies!
Q & A with Ward Richmond & Marc Maiona
By: Ward Richmond & Marc Maiona
As a commercial real estate expert, it is critical to have a base level understanding of the extremely confusing and subjective changes to new lease accounting standards which have been created by the FASB & IASB and are about to go into effect.
Yeah, I’m already confused too. I attempted to write this blog on my own for about 7 hours one day and then I had to throw in the towel. I did what I usually do when I don’t know the answer to something: I brought in an EXPERT.
You don’t need to master this info but I am confident that this Q & A with lease accounting badass, Marc Maiona, over at LeaseCalcs www.leasecalcs.com will provide you with the right amount of intel to sound dangerous and pick up some simple actionable items.
In case you only want to read 1 question and not 21, I suggest you scroll to #21. Trust me, #21 is jam packed with some quick and easy actionable items related to lease negotiation and administration strategies that you can utilize to take advantage of the new accounting standards!
That being said, if you want to know everything there is to know about these changes, start right here. Good luck, my friends. You’re gonna need it!
NOTE FROM WARD: SOME OF MARC’S RESPONSES HAVE BEEN EDITED & PARAPHRASED BY YOURS TRULY FOR THE SAKE OF BREVITY. IF YOU WANT THE FULL DOWNLOAD AND HAVE FURTHER QUESTIONS, PLEASE CALL MARC!
Are FASB and IASB somehow interconnected?
Technically, no. However, there has been an effort by both accounting boards to converge their respective accounting standards over the past several years. The new lease accounting standards were supposed to be one area where they would achieve one unified set of standards. Unfortunately, they did not achieve that goal.
When do new standards take effect?
Public companies must adopt new standards by 2019 and private companies by 2020.
The collective FASB and IASB goal was to achieve consistency and transparency. Was this achieved at all?
In my opinion, the FASB and IASB did not achieve either goal. Their respective standards are very different, such that the exact same lease being accounted for under IFRS versus under US GAAP will have completely different impacts on the balance sheet, shareholder equity, net income and EBITDA results.
Which companies use GAAP vs those that use IFRS?
It generally follows where a company is headquartered, or, in some cases, listed (i.e., on the NYSE vs. FTSE, etc.). US headquartered companies almost always report their consolidated financial results under GAAP; whereas, international companies tend to use IFRS.
How is a “lease” defined? Is it the same under GAAP and IFRS?
The definition of a lease is the same under both standards and is essentially this: a contract that conveys the exclusive use and control of a defined asset with no reasonable right of substitution of the asset.
How is Finance Lease defined? Is this the same under GAAP and IFRS?
Under IFRS the definition is easy — every lease is a Finance lease under the new IFRS standards.
Under GAAP, a Finance lease is any lease that meets any one of the following 5 criteria:
What are the positives of a Finance lease? Is this the same under GAAP and IFRS?
From a financial reporting perspective, the one big benefit of a Finance lease is it provides a significant boost to EBITDA performance as compared to an Operating lease. Accounting for Finance leases is also a bit simpler than the new Operating lease model.
What are the negatives of a Finance lease? Is this the same under GAAP and IFRS?
Due to the differences in the way the Right of Use Asset amortizes under a Finance lease versus an Operating lease, a Finance lease will have a more detrimental impact on shareholder equity than the same lease classified as an Operating Lease.
Additionally, Finance leases are technically classified as “debt” on the balance sheet, while Operating leases are not (Operating leases are classified as operating liabilities).
Finally, the expense profile of a Finance lease on the income statement is “front loaded”, meaning the combination of interest expense and amortization expense is higher at the beginning of the lease term than it is at the end, causing differing impacts to net income as the lease term progresses.
How is an Operating Lease defined under GAAP?
Any lease that is not a Finance lease.
Why does IFRS not use an Operating Lease? Did they ever?
In short, the IASB decided the complexity of the Operating lease model was not worth the purported benefits.
What are the positives of an Operating Lease?
Operating leases have a better impact on shareholder equity than the same lease classified as a Finance lease. Also, the straight line expense profile may be preferred by some companies as compared against the front loaded profile of a finance lease.
What are the negatives of an Operating lease?
Primarily the complexity of the accounting — though with our software the complexity goes away.
What impact do the new standards have on Sale Leasebacks?
There will be major impacts on both the “sale” accounting and the “leaseback” portion as well. The biggest impact or change has to do with the timing of how any gain (or loss) on the sale is recognized. Generally speaking, under current standards, the gain is required to be deferred over the leaseback period.
Under the new standards, the gain must all be recognized on the date of the sale!
This greatly changes the P&L profile of sale-leaseback transactions and is causing some companies to look to accelerate deals to have them close before the new rules take effect. It is worth noting the sale-leaseback rules – both current and new – have a number of nuances to them which can yield different outcomes. NOTE FROM WARD: NOW IS THE TIME TO DO A SALE/ LEASEBACK. TAKE ADVANTAGE OF THESE BULLISH MARKET CONDITIONS AND ACCOUNTING CHANGES SIMULTANEOUSLY!
Do you think the world would benefit from one set of standards or is it good we have two?
I think it would have been beneficial if the FASB and IASB had met their objectives of having consistent and transparent lease accounting, globally.
In a nutshell, what is happening with this whole change to lease accounting?
This is the end of off-balance sheet lease transactions (with the exception of very short term leases.)
Which companies are affected by this change in the accounting rules? Is it just publicly traded companies?
Public companies, private companies, non-profits and governmental agencies. The standards basically impact any company that is require to issue GAAP or IFRS audited financial statements.
Does this just effect new leases?
No, this applies to any existing lease that has any part of its lease term go beyond the effective date of the new rules (including any comparative reporting periods).
What changes are you seeing in the way companies are negotiating leases in light of these new rules?
These changes are driven by whether a company is more sensitive to the impact the new rules will have on their Balance Sheet / Shareholder Equity results or whether they are more sensitive to their Income Statement results, or even more specifically their EBITDA results.
One of the more interesting changes – and one that virtually nobody predicted when these rules were first proposed in 2010 – is the shift to longer term leases for companies that are focused on the impact their leases have on net income and EBITDA performance.
What are the biggest traps with these new lease accounting rules?
I think there are two really significant traps, one being more “big picture” in terms of the accounting and the other being more “transactional” on new deals.
The “big picture” trap is thinking about this all as purely an accounting exercise. Any company thinking that the change in lease accounting standards is merely an accounting exercise will miss tremendous opportunities to improve financial performance, potentially in a material way.
The “transactional” trap is not knowing the true financial statement impact of any lease while it is still being negotiated.
The commercial real estate brokerage world has almost exclusively relied on discounted cash flow analysis as it’s “go-to” analysis to help tenants decide what deal is the better deal.
That may have sufficed in a world where virtually all leases were off balance sheet. But the irony is this: there is not a company in the world that reports financial results on the basis of discounted cash flows. Discounted cash flow analysis will not suffice going forward.
Most of our customers are Third Party Logistics companies (3PL’s). How does this impact 3PL’s contracts with their customers?
Depending on company goals, 3PL’s should definitely consider a shift from a true “lease” with their customers to a “service contract” when possible. This shift can potentially generate value for their clients and keep these transactions off of the books.
A true “service contract” should be doable in shared warehouses. That being said, a “service contract” will not provide their clients with the exclusive use, access and control of a defined area like a lease can provide.
How can real estate brokers assist tenants in dealing with these new accounting rules, particularly as new leases are being negotiated or existing leases are being amended? NOTE FROM WARD: IF YOU ARE JUST GONNA READ ONE Q&A, READ THIS ONE!
There are a lot of ways for brokers to assist tenants here!
First things first: Brokers need to understand what is important to their clients!
Is it the Balance Sheet? Is it the P&L? Is it the EBITDA?
For Balance Sheet focused companies
For P&L Focused companies:
For EBITA Focused companies (This seems to be a common trend among my customers!):
If a company is considering a Sale Leaseback or a Sublease, NOW IS THE TIME!
There is also a tremendous opportunity for brokers and their in-house lease administration teams to help tenants through the transition process by:
Keep In Mind: It is only at that point in time – during lease negotiation – where a company can have any influence over what the accounting outcome will be, and this is why it is so important for the brokerage community to be that knowledgeable resource for tenants.