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April 2009

Changes are coming Highlights

• The International Accounting Standards Board (IASB) and its US counterpart The Financial Accounting Standards Board (FASB) jointly issued a discussion paper in March 2009 outlining dramatic proposed changes in lease accounting. • Operating leases as we know them will be eliminated and all leases will be capitalised on Balance Sheet. No leases will be spared, including leases signed before a change in standard. • Based on the proposed accounting changes, 25% of FTSE AllShare companies will see their debt load more than double ! • A final standard is expected to be issued in 2011 with a possible effective date of 2012 or 2013.

recognise off Balance Sheet obligations and put leases into plain view on the balance sheet, believing this will provide greater economic transparency. The nature of IAS 17 and its “all or nothing” outcome is frequently derided by critics who contend that the accounting treatments drive leasing behaviour. Tentative Conclusions Significant changes to lease accounting are certain. Deliberations since 2006 by the IASB and FASB have created consensus around a new conceptual framework that will capitalise all leases. The model tentatively adopted by the Boards is a “right-of-use” model. Simply put, when companies enter into leases, they acquire an asset which entitles them to use a specified property for a stated period of time. There is

Key Implications

inherently an obligation to pay rent for the right to use a physical

• All leases will be accounted for as if the lessee owns the asset with debt. i.e. operating leases will no longer exist

asset. This obligation is recognised as a liability.

• All leases will be “On-Balance Sheet,” by way of an asset and a corresponding liability. • The asset will be amortised over the life of the lease. •

The rental payments are split between capital and interest (like a mortgage). Hence the P&L cost will be front loaded as the interest element will be higher in the earlier years.

Background Concerns over off Balance Sheet accounting escalated earlier this decade with Enron and other notable corporate bankruptcies. The principles of lease accounting as we know them under IAS 17 are more than twenty five years old and have been an ongoing target of concern for the last decade. In July 2006, the IASB and FASB adopted a joint project to overhaul lease accounting. The stated objective of the project is to

The Boards made the following preliminary decisions:

• Capitalisation of leases based upon the present value of lease obligations, discounted at the lessee’s incremental borrowing rate. • Capitalised value will include base rent as well as an estimate of contingent rent, such as options to extend, as well as other payment amounts (not just the minimum or initial term). • Elimination of the distinction between operating leases and finance leases. • Change in the pattern of rent expense from straight line to a system similar to finance leases or assets owned with debt. • Changes in assumptions about a lease contract will trigger remeasurement in subsequent reporting periods. • Deferral of changes to lessor accounting based on revenue recognition project that is underway.

Factors for Occupiers to Consider

Major and Unexpected Impact The magnitude of change in financial reporting for leases will be daunting. It will touch virtually every organisation as most businesses lease some type of asset, be it real estate, computers, copiers or transportation equipment. The right-of-use method will dramatically alter financial statement presentation and financial performance measurements. Metrics that tie into management objectives and compensation and debt covenants will need to be examined and likely changed, especially as they affect existing borrowing arrangements. Substantial impact includes:

• Ballooning of corporate balance sheets by the capitalised amount of existing leases. • Increase in P&L expense during the early years of a lease – by as much as 25% - and decline in the later years of a lease. The graph below shows the difference between a finance lease and an operating lease for a 20 year lease, with fixed rent of £1.0m per annum. In the early years, the depreciation of the Finance Asset and the interest (finance lease) outweighs the rent expense (operating lease). Under the new rules all leases will be treated as finance leases. 20 year lease - P&L comparison Annual Rent (£m)

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• The “Own vs. Lease” decision should be more commercially driven and less focused on accounting as the differences between them will be less dramatic. • The length of leases on sale and leasebacks will be driven more by occupancy and market factors, rather than accounting issues such as avoiding finance lease treatment • Clauses previously avoided, such as right to buy at expiry on non-market terms, can be considered without as much concern for accounting impact as all leases will be finance leases. • The commercial terms of any lease do not actually change, so there will be no impact on the cash cost of the lease. What Next? There are further decisions still to be made on certain topics where the IASB and FASB have not reached agreement. Among these are:

• Treatment of sale-leasebacks and build-to-suit arrangements • Triggers for subsequent remeasurement of lease obligations and the approach e.g. will leases be remeasured at the original or then current discount rate? • Treatment of common lease features such as renewal options, contingent rent and purchase options. • Should subleases follow the same treatment? • Exception for non-material and short duration leases

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Public comment on the Discussion Paper is invited by July 17,


2009. Thereafter, the Boards will continue deliberations with the


intent of issuing an Exposure Draft in 2010, leading to the issue

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Finance Lease P&L

Operating Lease P&L

of a final standard in 2011. The effective date of a new standard has not yet been agreed, but is expected to be 2012 or 2013. Questions?

• Without some provision for transition, total occupancy expense for a lease portfolio will swell in the first years after a new lease accounting standard until a company’s portfolio “matures.” • Increase in EBITDA (cash flow) as rent expense which was above the line will be replaced by some form of amortisation and financing charge added back to cash flow. • Overwhelming administrative burden to track all leases - no matter how small or short - a task borne by large and small businesses alike.

Jones Lang LaSalle will continue to monitor the lease accounting project. Most companies will be affected and should begin to examine the impact on their Financial Statements. Questions can be directed to the Corporate Finance Team: Richard Porter (Associate Director) (+44 (0) 20 7399 5604) Michael Evans (National Director) (+44 (0) 20 7399 5575) Matthew Richards (National Director) (+44 (0) 20 7399 5458)

Microsoft Word - 09 04 09 Operating Leases Perspectives v14 Final.rtf