Getting Ahead of Lease Accounting Changes – Positioning Your Real

Estate Portfolio

Session 2.08

“The Lease Accounting Changes Are Coming”

• “$1.3 trillion dollars is expected to be placed on the balance sheet by public companies alone” – Securities and Exchange Commission

• “Reported debt load will be increased by 58% on average” – PWC and Erasmus University

Every organization will be affectedIs yours ready?

The Headlines

Learning Objectives

• Review the latest FASB changes being considered and upcoming milestones in the approval cycle.

• Understand the pros and cons of leasing and owning, considering the proposed FASB changes.

• Discuss what effect the FASB rule changes will have on the financial picture of your company.

• Learn what terms you should seek when negotiating leases to best position your portfolio given the proposed FASB changes.

Mark Ellis – Director, Global Facilities & Real Estate - Tekelec

Doug Moxley – Vice President of Finance - Xirrus

Portfolio manager responsible for 26 leased locations around the globe completing over 75 transactions in his six years in the position. The substantial leasing profile within the portfolio has required him to follow and be up-to-date on the proposed accounting rules

Doug has over 15 years of experience serving at the highest levels in Finance organizations for technology companies. His experience in both public and private sectors allows for a full understanding of the accounting implications of the upcoming changes

Michael Billing – Executive Vice President – Jones Lang LaSalle

Michael has over 18 years of professional services and client advisory experience leading to his current role as Jones Lang LaSalle’s Lease Accounting Project Director with responsibility for all activities related to the proposed lease accounting changes.

Meet Our Presenters

Background of Proposed IASB/FASB Rule Changes• FASB and the IASB are proposing new accounting rules in an effort to improve

transparency

• Exposure draft is scheduled to be published during Q2 2013, final standard is expected to be announced at the end of 2013 or early 2014, with changes likely to be effective no earlier than 2016; however, due to financial reporting rules, clients will have to report two years of comparative financial statements at the implementation date, and there will be no grandfathering

• Eliminates distinction between operating and financing/capital leases with all leases going on balance sheet - lessee to recognize an asset representing its right to use the leased asset for the lease term and a liability to make payments

• For some leases (significant scrutiny on real estate leases > 10 years), expense to be accelerated, unlike current lease accounting straight-line methodology

• Proposed changes impact all leases – real estate and equipment

• Will impact all companies that report financials under either U.S. GAAP or IFRS (International Financial Reporting Standards) – this is a global issue

Background of Proposed IASB/FASB Rule ChangesProposed lessee model• Lessee to recognize an asset representing its right to use the leased asset for the

lease term and a liability to make payments

• Leases of property (land or a building—or part of a building—or both) expense using the straight-line approach (current methodology) unless the lease term is for the major part of the economic life of the underlying asset; or the present value of fixed lease payments accounts for substantially all of the fair value of the underlying asset

• Auditors will likely scrutinize leases > 10 years

• Non-property leases expense to be accelerated (akin to a loan amortization schedule), unlike current lease accounting straight-line methodology

• Proposed changes impact all leases – real estate and equipment

Background of Proposed IASB/FASB Rule Changes

Comprehensive overhaul of lease accounting standards under FAS 13 and IAS 17 – lessees and lessors, with an objective to capitalize all leases and create economic transparency

Current Status of FASB Rule ChangesTimeline

Lease vs. Own Considerations• The criteria for deciding whether to lease or buy needs to be carefully re-examined

• With the new standard, balance sheets will grow from capitalization of operating leases

• But balance sheet management may still occur through lease structures and decision-making

• Organizations should focus on capital strategy, operating requirements, flexibility, and economics

• Sale and leasebacks transactions - sales of property meeting criteria under revenue recognition standard will treated as sales with immediate profit and loss recognition regardless of leaseback – no deferred gain under U.S. GAAP

• Potentially eliminates capital efficiency benefits (ROA) of leasing

• Potentially shifts expense profile to below the EBITDA line

• Decisions will be based on economics, not accounting

- Need to consider a company’s cost of capital

Effect on AccountingSignificant judgments equal increased workload and scrutiny

Effect on AccountingProposed accounting treatment

Current Standard

Recognition of Leases under New

Standard New StatndardCurrent Assets 5,000 - 5,000 Non Current Assets 2,000 2,000 4,000 Total Assets 7,000 2,000 9,000

Current Liabilities 3,000 - 3,000 Current Portion of LT Debt 500 400 900 Total Current Liabilities 3,500 400 3,900

Long Term Debt 1,000 1,600 2,600

Total Liabilities 4,500 2,000 6,500

Equity 2,500 - 2,500

Total Liabilities and Equity 7,000 2,000 9,000

Debt to Equity 1.80 2.60 Debt Ratio 0.64 0.72 Current Ratio 1.43 1.28

Effect on accountingBalance Sheet Example

Effect on accountingIncome Statement Example

Current Standard

Recognition of Leases under New

Standard New StandardRevenue 15,000 - 15,000 COGS 7,500 - 7,500 Gross Margin 7,500 - 7,500

Operating Expenses (Rent) 6,000 (400) 5,600

Operating Income 1,500 400 1,900

Interest / Amortization Expense 150 600 750

Net Income Before Taxes 1,350 (200) 1,150

Income Taxes 459 (68) 391

Net Income 891 (132) 759

EBITDA 1,500 1,900 EBITDA / Revenue 10.0% 12.7%

• Balance sheets will grow significantly

• Net income will be diminished due to the higher reported lease expense, but EBITDA will grow

• Geography of expense will move on the P&L – no more rent, just amortization and finance expense

• Change in key performance ratios such as leverage / cash flow may impact covenants

– Legacy agreements / fixing the gap

• Potential volatility in income statements– At transition– Ongoing due to continuous reassessment

Effect on accountingFinancial implications

Stakeholders Affected by Accounting Changes

Consider communication plan for key stakeholders:

• Shareholders

• Board of Directors

• Investment Analyst community

• Bank and other finance companies

• Business partners

Potential System Integration Issues

• Lease Accounting tools and ERP systems need to evolve in time to record results for current and final new rule sets when the interim period starts

• Expense algorithms are different

• Recording and tracking of right-of-use asset and liability to pay lease payments

• Many judgments will need to be memorialized for audit purposes

Transaction Lease Structuring

• Leases will likely focus on:

• Lease term

• Rent escalations

• Contingent rent

• Extension options

• If these are included in the lease, they may have to be recognized as part of the term, which could make a significant balance sheet impact, whereas today they aren’t

• Any other factors that will impact capitalized amount

Positioning your Lease PortfolioTaking the right steps to prepare

Learning Objectives – Accomplished!

• Reviewed the latest FASB changes being considered and upcoming milestones in the approval cycle.

• Understand the pros and cons of leasing and owning, considering the proposed FASB changes.

• Discussed what effect the FASB rule changes will have on the financial picture of your company.

• Learned what terms you should seek when negotiating leases to best position your portfolio given the proposed FASB changes

21

Questions & Answers

Track the Latest Developments and Information

Visit www.LeaseAccountingChanges.com

•Follow the Blog to get current information and perspectives

•Register and use impact calculator

•Download preparedness checklist

•Ask questions and get answers

•Read articles and perspectives

•Get info/updates regularly

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