KBA has received numerous responses to our latest Lease Tip, The Impact on Corporate Real Estate of Lease Accounting Changes under GAAP. We are preparing to provide comments to the FASB/IASB exposure draft regarding the following aspects of the changes and would like to invite you to join us.
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Response to Question 6 (page 7): Contracts that contain service components and lease components
In most real estate leases, in addition to the liability to make the lease payments, lessees will also be liable for the costs to operate, repair and maintain the underlying leased asset, including annual operating expenses, real estate taxes and insurance costs (“Operating Expenses”). In some leases these are referred to as “Common Area Maintenance.” There are generally three types of real estate leases categorized by the extent to which Operating Expenses are included in the periodic lease payments. They are as follows:
A “NET” lease – no Operating Expenses are included in the periodic lease payments.
A “GROSS” lease – all Operating Expenses are covered by the periodic lease payments.
A “MODIFIED GROSS” lease – only the initial year’s Operating Expenses (the Base Amount) are included in the periodic lease payments. After the initial year of the lease term, the lessee is liable to the lessor for the annual increase in Operating Expenses over the Base Amount. MODIFIED GROSS leases, are the favored form of lease commercial office lease in the United States.
The March 19, 2009 Discussion Paper on Leases, Chapter 9, sections 9.23 – 9.25 “Leases that include service arrangements,” discusses the requirement of current accounting standards that payments for services be separated from rental payments.
Is paragraph 6 in the “Scope” section of the Exposure Draft modifying the current requirement to segregate Operating Expenses in real estate leases? If not, it would appear that the Operating Expenses under a GROSS lease would not be distinct and therefore the entire contract would be treated as a lease.
Although there is no easy way to segregate the service components from the lease components in a GROSS lease, in a MODIFIED GROSS lease the Operating Expenses are either specifically identified or can reliably be estimated at lease inception. Thus, the service components and lease components can reasonably be and should be apportioned prior to measurement of the right-of-use asset and liability.
Please consider the foregoing and provide further guidance and clarification.
Response to Question 8 (page 8): Lease Term
The Exposure Draft proposes that the assumed lease term should be the longest possible term that is more likely than not to occur, taking into account the effect of any options to extend or terminate the lease. Regarding leases of real estate, if an entity is considered to be a going concern, why would the term used to measure the right-of-use asset and liability to make lease payments be limited to just option periods? As a going concern, the entity’s real estate needs will not end after all options expire. They will continue perpetually into the future. If options are not exercised or a lease is simply allowed to terminate, the entity, still in need of real estate, will merely change leased locations (assuming it decides that leasing rather than purchasing is still the more favorable alternative). As the specific location is not relevant to the measurement of the right-of-use asset and liability to make lease payments, then why is the assumed lease term limited by the contract terms for each specific physical location? And if the need to lease an underlying asset for a going concern is perpetual, how can the present value of the lease payments be determined? Finally, most negotiated options are merely used by tenants as leverage to renegotiate the terms of the lease when approaching the end of the stated lease term. Most options are not exercised exactly as originally negotiated.
Once one considers option periods beyond the term for which an entity is legally liable to make lease payments, why limit the assumed lease term to only those option periods stated in the contract? Perhaps the assumed lease term should be based on an entity’s long-term business plan and its estimated leasing needs to enable it to provide a particular market or region with its products and/or services. This approach de-couples the assumed lease term from a specific physical location and more closely matches the measurement of the right-of-use asset and liability to make lease payments to an entity’s underlying business needs. Of course, this approach will make estimating the relevant lease factors more difficult, as they will, in many cases, most likely extend far into the future.
Alternatively, perhaps the assumed lease term should initially be limited to periods only for which a legal liability to make lease payments exists. Then, when options are actually exercised or the lease terms are renegotiated, or the lease for the underlying asset terminates and the entity moves its operations to a new leased facility, the right-of-use asset and associated liability would be re-assessed at that time.
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