The Financial Accounting Standards Board ("FASB" or "the Board") recently decided to re-expose its proposal for revised lease accounting standards for public comment and input, in light of the many changes in the lease accounting proposal from those set forth in the original August 2010 Exposure Draft (the “Exposure Draft”).
In addition, several substantive, albeit tentative, decisions have been made by the Board in regards to the proposed changes to GAAP lease accounting, since our last updates in November 2010 and March of this year, and the picture of what the final lease accounting rules are likely to look like is becoming clearer.
Included among these are the following:
- FASB affirmed that the new lease standards will include within their scope both subleases and longterm leases of land (i.e., ground leases).
- In discussing the inclusion of the tenant’s lease payment obligations in the tenant’s liabilities and the landlord’s assets, the Board decided that such liabilities and assets should include not only the rentals for periods covered by renewal and extension options, but also the sums payable by the tenant under a purchase option, where there is “substantial economic incentive” for the tenant to exercise the particular option. Where such an incentive exists, in the case of a purchase option, the underlying asset recognized by the tenant would naturally be amortized over the entire economic life of the asset, rather than just the lease term.
- In analyzing the types of changes in circumstances which should be analyzed in reassessing whether or not a tenant has “substantial economic incentive” to exercise an option, FASB decided that changes in market rental rates after lease commencement should not be considered in making such reassessments. This decision should preclude a pre-determined rental rate applicable to a renewal option from being considered to be a “substantial economic incentive” merely because market rental rates increase after the lease is signed.
- The Board decided that the proper date of recognition and measurement of lease assets and liabilities, and of determination of the discount rate to be used in making those calculations, should be the date of commencement of the lease, rather than the date of inception of the lease. This should result in recognition of such assets and liabilities taking place when rental obligations commence, rather than when the lease is signed.
- FASB also decided that lease incentives provided to a tenant should be deducted from the initial measurement of the tenant’s leasehold asset, and that both tenants and landlords should be required to capitalize all initial direct costs (such as brokerage commissions and legal fees) incurred in putting the lease in place.
- The Board also determined that in a sale/leaseback transaction, the tenant should generally be required to treat such transaction as both a sale and a lease, with the lease component being treated in accordance with the new GAAP standards.
- As to variable lease payments (such as percentage rent in a retail lease, or rents which have CPI-based inflators) required to be included in tenants’ lease liabilities and landlords’ lease assets, two decisions were reached. First, while the Exposure Draft initially proposed to include in such calculations variable lease payments that were deemed to meet a high threshold of certainty (as to their coming due and the amount thereof), the Board subsequently decided not to include such payments in lease-related liabilities and assets, no doubt in part due to the practical difficulty of determining which payments would so qualify, and calculating the amounts to be included. Second, as to variable lease payments that depend on an index or rate (for example, CPI-based inflators), FASB elected to have such payments be determined using the index or rate in effect at the date of commencement of the lease, and to also require reassessment at each subsequent reporting period using the rate then in effect. This decision will have the unfortunate effect of increasing accounting costs by forcing reassessment of such payments with each reporting period.
- In earlier meetings, the Board had considered the possibility of providing for two different accounting approaches for tenants, one approach being consistent with the Exposure Draft and applying only to “finance leases,” and the other approach providing for amortization of the leasehold asset and rental liability on a straight line basis for “non-finance leases.” This proposal appeared to be intended to avoid the distortive effect of the Exposure Draft approach on net income for tenants under “non-finance leases,” since that approach generally increases tenants’ expense deductions during early years of the lease term, and reduces them during later years of the lease term, versus the straight line deductions for rent expense which would be the case under the current rules governing operating leases. However, the Board subsequently decided to revert to a single approach for tenant accounting, that being the approach mapped out in the Exposure Draft. This decision will no doubt be a disappointment to tenants (particularly publicly traded tenants) concerned about the impact of the Exposure Draft approach on their GAAP net income.
- Ending the internal debate as to whether or not to use a single or dual approach to landlord accounting (with different treatment being afforded to landlords under leases which transfer substantially all the risks and rewards associated with ownership to the tenant, presumably a reference to long term socalled “triple net” leases), FASB decided to adopt a single approach for landlord accounting. Pursuant to the approach adopted by the Board, landlords will apply a “receivable and residual” approach, involving recognition of an asset in the form of a right to receive lease payments, valued on a discounted present value basis, and recognition of a residual asset as an allocation of the carrying amount of the underlying asset, with the residual asset being accreted over the lease term. Interestingly, in the event that a profit on the lease transaction (i.e., a situation in which the value of the rental receivable plus the residual value of the underlying asset exceeds the book value of the underlying asset) is “reasonably assured,” the landlord is required to recognize that profit at the commencement of the lease.
- As to timing of the announcement of the final lease accounting rules, the Board had originally projected such announcement to occur during the second quarter of 2011, but that has been moved back to the third quarter of 2011 in its more recent minutes. In light of the Board’s election to re-expose the revised accounting proposal for public comment, it now appears that Q3 2011 is anticipated to be the time period when the revised exposure draft will be issued for comment, rather than when the final rules will be issued. The date when the new rules would be required to be implemented is still quite uncertain, but it is anticipated that implementation would be delayed by at least a few years. Once the rules take effect, however, it is clear that the rules will apply to leases already in place, i.e., that existing leases will not be “grandfathered.”