Pre-lease Issues

Update on Proposed Lease Accounting Changes – Heeding Industry Comments

Responding to the comments from the corporate real estate industry, several weeks ago the joint accounting boards (FASB and IASB) softened their position on some controversial points in their August 2010 draft lease accounting proposal. Two major criticisms of the August 2010 draft were: (1) it would hamper the real estate recovery as many tenants would gravitate toward shorter lease terms which would “throw a curve ball” to the already fragile capital markets; and (2) it would be highly subjective, complex, and administratively burdensome accounting for tenants. Below is a recap of the Boards’ two major changes to their August 2010 draft.

1. Re-classifying leases. Instead of all leases being treated as a finance lease, the Boards have created two types of leases: (1) finance lease – as under the August 2010 Draft; and (2) “other-than-finance” lease. The latter classification was created in recognition that not every lease is a financing transaction. It also addressed the concern that the front-end loaded annual interest expense being amortized would hurt tenants and, in particular those who can least afford it, new businesses. Like the current treatment of operating leases, the “other-than-finance” lease will be straight-lined over the term while recognizing the transaction as a “right to use” asset and corresponding liability.

2. Lease Term to include options on a limited basis. Removing some of the speculation on measuring lease terms with lease options (renewal or termination), options are only considered where there is “significant economic incentive” for them to be exercised. This assessment is made at the commencement of the lease. Unlike the August 2010 draft which would have required continual reassessments of the lease options, the Boards have indicated that a tenant would only need to reassess the lease term when there is a “significant change” in economic factors. Practically speaking, as most renewal options are at “market” (as opposed to predetermined terms), it would seem difficult to state upon entering into a 5 or 10 year lease that there is a “significant economic incentive” for the tenant to renew. Likewise, as a termination fee under most termination options is less than the remaining lease obligation, what determines a “significant economic incentive” to terminate the lease?

While it is refreshing to see that the Boards are listening to the industry and its concerns, it does not seem likely that pendulum will swing fully back to where things are today. Stay tuned….

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