Finalizing the changes is taking much longer than anticipated. This means the effective date of the changes will be pushed off farther into the future, giving companies more time to deal with the impact. As you have  probably heard, extensive public comment over the proposed changes in the Boards’ original August 2010 Exposure Draft have prompted them to re-expose a revised proposal sometime during the second half of this year, followed by another public comment period and perhaps further revisions. This extended period of deliberation clearly signals that the Boards are carefully considering industry criticisms and suggestions and will take all the time necessary to  properly account for the economic realities inherent in the various types of leasing transactions.  

At their last meeting in late February 2012, the Boards discussed lessee accounting and, in particular, different methods of amortizing the right-of-use asset. They also discussed any consequences that a change to the lessee accounting model would have on the tentative decisions for lessor accounting. The Boards were not asked to make any decisions. The Boards directed the staff to undertake further outreach and research on the alternative lessee amortization approaches before they reach a tentative decision on which approach to propose in the re-exposure draft.

Without getting into the accounting “weeds” it appears that the FASB and the IASB are at odds regarding which amortization approach to propose. The amortization approach determines the P&L pattern a company must recognize for each lease transaction. The FASB favors a newly introduced “interest-based” approach which would generally result in straight-line P&L and only be applied to the former operating leases (the former capital leases would continue to be amortized per current GAAP).  In contrast, the IASB favors an “underlying-asset” approach which would result in a P&L pattern consistent with the asset’s depreciation method, had the lessee owned the asset and would apply to both the former operating and capital leases.

When the Boards voted we were left with a clean split- the FASB fully supporting the “interest based” method and the IASB in favor of the “underlying asset” approach.  Lessees have already commented that they think both new methods are overly complex and potentially unworkable.  Interestingly, no voter agreed that they would switch their vote to the other method if their own approach proved unmanageable.  Stalemate anyone?

The Boards have planned one more meeting to see if they can work out a compromise regarding this very significant P&L pattern issue. If not, the FASB and IASB could issue two different re-exposure documents, both subject to public comment.

So we still have a long way to go before the final changes to the lease accounting standards are enacted, and an even longer way before the new standards must be implemented. The current consensus is that the first set of financial statements which would be required to reflect the new standards would be no earlier than for the year ended 2015 or 2016.  However, as these statements would necessarily include a comparison to the prior two years, the changes would also need to be reflected in the 2013 or 2014 results at that time as well.  So take a breath, enjoy the summer and BE HAPPY. When the time is right, KBA and Visual Lease will be ready to assist your companies with the transition to whatever new standards come our way.

So you’ve signed a lease as a tenant; months of bargaining with landlords, lawyers and brokers have resulted in a complex document that establishes what you will and will not pay for.  The lease then provides that although the landlord agrees to not charge you for certain things, if by some accident it makes a mistake, it is your duty to find it and ask for a correction.  This self-imposed shift of responsibility takes all the teeth out of what you fought for when defining your payment obligations. 

But wait– it gets worse.  Not only must you find and point out these errors, most tenants voluntarily agree to do so within a very short window.  Although the tenant by law has multiple years (6 in New York) to bring billing errors to the landlord’s attention, many tenants have acquiesced in allowing these limits to be shortened to as little as 30 days!  The result?  Not only do tenants have the onus to notify their landlords of billing irregularities, but now they have vastly shortened time periods to do so!  A somewhat common example of such a provision is as follows:

Any Landlord’s Reconciliation Statement (the “Statement”) sent to Tenant shall be conclusively binding upon Tenant unless, with 30 days after such Statement is sent, Tenant shall send a written notice [which must follow the lease’s Notice provisions] to Landlord objecting to the Statement and specifying the respects in which the Statement is incorrect.

Commercial tenants should be receiving their 2011 operating expense and tax reconciliation statements from their landlords by no later than the middle of Q2 2012.  These reconciliations are essentially accountings of the actual 2011 expenses compared to the estimated expenses paid in 2011.

These receipt of these statements starts the clock on the time limits within which a tenant must notify its landlord of errors, and as stated, the failure to raise an issue by the prescribed deadline means the expenses in the statement are “deemed” conclusive and become binding on the tenant, regardless of how blatant or obvious they are.

The difficulty for most tenants is that it often takes up to 30 days just to pay the bill, and for a tenant to do all that is necessary to identify potential overbillings and then explain them in a notice to the landlord is a near-impossible task.  Furthermore, for tenants with multiple leases, managing these audit windows can be a nightmare.

Solution #1 – Stop Giving Away the Store!

For new leases, we strongly we urge tenants, attorneys and brokers to steer away from unreasonable restrictions on the tenant’s ability to verify its charges.  Given that the tenant is doing nothing more than ensuring compliance with the parties’ agreement, the tenant should have as much time as it reasonably needs to identify and present errors.  No tenant should voluntarily give its landlord the ability to keep funds that should never have been billed in the first place, simply because the tenant did not find them in time.

Balanced Lease Audit Language*

In order to verify the accuracy and validity of the charges set forth in the Operating Statement, the Tax Statement and any other charges imposed on Tenant for Additional Rent (collectively, the “Charges”), Tenant shall have the right, upon reasonable written notice to Landlord and at Tenant’s sole expense, to examine or have Tenant’s representatives examine the records as are relevant thereto, including the general ledger, escalation worksheets, invoices, canceled checks, contracts and other supporting records (collectively, the “Records”).  If after its review Tenant disagrees with the Charges, Tenant may send a written notice to Landlord of such disagreement specifying in reasonable detail the basis therefor, the amount it claims was not due and the amount of any refund it is claiming.

Solution #2 – Manage Your Critical Dates

For existing leases, the first step is to organize them in a way that makes such time-based restrictions easy to track.  A “best practices” approach is to automate a critical date reminder system that alerts the appropriate parties of such restrictions at predefined intervals.  For that reason, we encourage lease analysts, brokers, administrative staff etc. to research point solutions in the form of lease administration software to accomplish this task (visit www.capterra.com or www.softwareadvice.com for an overview of the lease administration systems market).

Solution #3 – Act within Your Time Limits  

Tenants should establish protocols to check each lease immediately upon receipt of the reconciliation statement.  Follow these steps:

1. Locate the audit rights provision in each lease.  It will prescribe the amount of time you have to object to the charges on the bill and how you must proceed with an audit of the landlord’s books and records.

2.  Thoroughly review the statement against your lease before contacting the landlord and effectively beginning an audit.

a.  Review operating expenses like base year adequacy, pro-rata share calculations, allocation of expense pools, expense stops, exclusions and passthroughs, caps, capital expenditures, management fees extraordinary charges, sundries, after hour HVAC, freight elevator usage and all CAM components.

b.  Review base rent issues like per square foot rent calculations, CPI calculations, rent commencement issues, subtenant chargebacks, tenant improvements and other credits.

c.  Check real estate tax billings for refunds, tax certiorari proceedings, improper inclusions and improper allocations.

d.  Check utilities and electric expenses for application of rates, proper schedules, surcharges, correct meter allocation and reading, and usage assumptions.

e.  Create trend reports and compare data to similar markets.

f.  Analyze the sufficiency of lease language with respect to all of these areas and identify areas of prospective exposure.

As you can see, it is somewhat inappropriate to saddle the tenant not only with the burden to identify errors, but also to do so in a vastly shortened time period.  This is particularly evident when you consider the fact that landlords have no such obligation.  In other words, the landlord can retrospectively charge its tenants for underbillings it discovers at any time during the life of the lease.  Tenants should at least feel comfortable demanding a little quid pro quo- if the tenant has 30 days to catch an error or forever hold its peace, the landlord should operate under the same restriction.

If you have any questions about how to set up such a process to better control your total cost of occupancy, please do not hesitate to give us a call, or visit our website at www.kbalease.com.

In 2009, ABC Company moves into a building that is only half occupied.  ABC signs a 10-year base year lease, where it agrees to pay for increases in building expenses over time, with 2009 serving as its base year.  The lease states that as building expenses rise from year to year, the landlord is to compare them to the expenses from 2009, and send ABC a bill for its share of the difference.

Over the next two years, the building starts to fill up as the landlord periodically leases out the remainder of the vacant space.  By 2011, the building is 100% full.  Everyone is happy, and everything feels right for each tenant, on every floor.

But something is wrong. For some reason in 2011, ABC receives a bill that is 10 times greater than expected! 

How Did This Happen?

The landlord had simply done what the lease required:  it deducted the 2009 Base Year expenses from the 2011 expenses and charged ABC for its share of the difference.  But because the building was only half full in 2009, many of the building’s expenses were far below normal, causing the spread between 2009 and 2011 to be exaggerated.  Even though expenses at similar buildings had risen by only 4% over those two years, the increase here was over 40%!  ABC had not anticipated this, and had only budgeted for a normal increase in costs.  This caught everyone by surprise and things started to feel much less right.

How to Fix This

ABC, either directly or through its lease audit professional, would have to work with the landlord to adjust the 2009 Base Year expenses to what they would have been at full occupancy (“grossed up”).  By doing this, both 2011 and 2009 expenses would be based on a full building and the only difference in costs would be those caused by normal increases. 

The argument goes as follows: ABC should not be forced to pay for large increases that were not part of the underlying business deal.  After all, both ABC and the landlord had expected that ABC would be paying only for the normal inflationary changes to building costs.  Instead, ABC was being charged to bring the building up to full occupancy.  In this case, the base year should have been set at  the true cost to operate the building at full capacity.  And because base year expenses are used each year when calculating a tenant’s charges, this anomaly will result in overstated charges for every remaining year of its term!  The moral of this story is that tenants should not be penalized for moving into a building that is not fully occupied when their actual use of space does not increase. 

Preventative Solution:  Better Lease Language

Leases should contain a so-called “gross up” clause, requiring adjustments to expenses to account for building vacancies.  They should state that in any year in which there is building vacancy, the expenses must be adjusted (grossed up) to what they would be if the building had been full.  This would have automatically required the normalization of 2009 expenses for ABC so that when the landlord calculated ABC’s increase, there would have been no fluctuations based on changes in occupancy. 

Conclusion

Building vacancy causes problems in expense pass-throughs, and tenants would be wise to include properly worded gross-up clauses in their leases.  In addition, even in the absence of a gross-up clause, tenants should seek the help of a qualified lease audit professional to identify expense anomalies and take steps needed to bring the lease back in line with the underlying business deal.

Gone are the days when tenants could comfortably rely on their landlords to follow the leases when billing ancillary charges such as operating expenses, taxes and sundry charges.  In fact, as the real estate market has softened, landlords are devoting more time and resources to finding new and creative ways to increase revenue (See “Revenue Recovery” in Commercial Investment Estate Magazine).  As evidence of this, landlord-side audit programs have become more prevalent, and many tenants are being jolted by new and revised operating expenses bills that go back several years. 

Ironically, landlords have been successful at limiting their tenants’ reciprocal ability to review the accuracy of the charges.  Note that under the guise of granting their tenants “audit rights,” Landlords actually take them away!  Audit rights in leases are almost always more limiting than what the tenant can do in the absence of such rights.  Sending an incorrect bill constitutes a breach of contract, which gives a tenant the right to recover lease overcharges anywhere from 4 to 10 years, depending on the state.  (For a more detailed discussion of lease audit deadlines and other restrictions, see our LeaseTip™ – “Negotiating Lease Audit Rights.”). 

Now, more than ever, tenants should be reviewing their leases and bills to make sure they do not contain overcharges or errors.  Here are a number of important reasons why tenants should increase their vigilance with respect to operating expenses and other pass-through charges:

1. The onus is on you to point out errors.  

At the beginning of each year, landlords reconcile their buildings’ actual expenses with the estimated amounts paid by their tenants during the prior year. They then issue adjusting statements to settle each tenant’s liability and establish the new estimates for the current year.  Even though landlords must follow the leases when issuing these statements, they have no incentive to self-police their charges and place the burden on tenants to identify errors and bring them to their landlords’ attention.  If they don’t, the bills are considered conclusive and binding on the tenant.  What’s worse, tenants have a very short period of time to both identify and dutifully object to such errors; which brings us to . . .  

2. Time works against you.

Unfortunately, many tenants agree to lease provisions that provide very short windows (usually 30-120 days) and particular procedures (who can audit and how) to object to billing errors.  If the tenant does not object in time or does not follow the correct procedures, the statements are deemed correct and errors are no longer fixable.

 3.  You spend the time and resources to create a particular lease, but you don’t get the special treatment you deserve.

Although many commercial leases share a common basic structure, they almost always result in a labyrinth of unique terms and lists of conditional operations after the negotiation process is complete.  This time-intensive process can result in confusion and, in many cases, imperfect lease language.  What’s more, many landlords do not put in the time to tailor charges to each tenant’s lease, thus ignoring the particulars of their individually negotiated terms and instead following the building’s standard lease.  As you would expect, the standard terms inevitably favor the landlord.    

4.  Mistakes happen.

Due to the complexity that results from the negotiation process, it is common for tenants to be incorrectly billed.  In fact, over 85% of all commercial leases are being overbilled; if tenants are not comparing their individualized provisions to the landlord’s current billing practices, the chances are great that errors exist and that the tenant is paying for them.  

These errors can range from simple miscalculations to wholesale misinterpretations of lease language.  Many mistakes are unintentional; some are not.  In fact, many property managers just do not understand the nuances of what was negotiated because they were not a party to the deal and are rarely attorneys.  Regardless of the cause, errors can result in significant overcharges over time and, if not corrected, are assumed to be accepted and become embedded in the deal.  For examples of the types of errors that occur, see our list of Sample Issues.

5. Operating expense and tax pass-throughs are expensive.

Real estate can be one of a company’s most significant expenses, and commercial leases are one of its key components.  Up to 70% of the cost of a lease can represent the tenant’s obligation to share in building operating costs, taxes and utilities.

6.  Your landlord’s CPA’s certification doesn’t mean your bills are correct.

Even though your landlord’s CPA firm may have certified your landlord’s financial records, they never certify each tenant’s bill.  Furthermore, landlords’ CPA firms typically certify that the operating expenses are properly treated from an owner’s point of view for financial reporting or tax purposes, not from the point of view of a lease pass-through clause.  (For a more detailed discussion of lease audit deadlines, see our LeaseTip™ “A CPA Certification is Not Enough.”)  

What’s the fix?

Given the increasing prevalence and impact of overcharges, tenants need to review their leases and bills on a regular basis to make sure they do not contain such costly errors.  Taking advantage of the increased availability of affordable software designed to help manage leases and their related expenses will allow tenants to catch many of the errors before they agree to pay.  Another proactive way to circumvent these issues is to add a well-defined lease administration process.  If structured appropriately, a good lease administration team will add a new level of control over occupancy costs; especially when paired with a simultaneous lease audit function, adding an even deeper level of protection.

Andrew Zezas, President of Real Estate Strategies Corporation and president of SIOR NJ interviews Marc Betesh, President and CEO of KBA Lease Services, about upcoming FASB changes.

Click here to view the video on YouTube.

Click here to view the video on YouTube.

Don’t miss the discussion between Andrew Zezas of SIOR NJ and Marc Betesh of KBA Lease Services.  Together they outline the upcoming changes to lease accounting under GAAP and their potential impact on commercial real estate, developers and occupants. 

Topics Include

FASB and IASB:  Who Are They and Why Are They Important?
Upcoming Changes and Reasons behind the Initiative
Treating a Lease like an Asset
The Effect of Draft Delays, Roundtables and Comment Letters
Renewal Options and Inaccurate Projections
Evaluating the Likelihood of Exercising Options and Economic Incentives to Renew
What Tenants Should Do Today

Andrew Zezas, SIOR, 2011 President of the New Jersey Chapter of the Society of Industrial and Office Realtors, interviews Marc Betesh, President and CEO of KBA Lease Services, about upcoming FASB changes to lease accounting.  Subsequent to this interview, FASB announced that it would defer issuance of the revised Exposure Draft to the first half of 2012.

Click here to view the video on YouTube.

Affirming the Boards’ intent to drastically overhaul the way leases are accounted for, Leslie F. Seidman, Chairman of the FASB  noted, “During our discussions of the extensive comments we received on the exposure draft, the boards have reaffirmed the major change to lease accounting, which is to report lease obligations and the related right-to-use on the balance sheet.”

The FASB website indicates that the new exposure draft will be reissued by Q4 of 2011.  Hans Hoogervorst, Chairman of the IASB, realizes the need for comment: “Although we have yet to conclude our deliberations on this project, the direction of travel indicates that there are aspects of our revised proposals that would benefit from additional input from interested parties.”  One thing weighing in favor of the Boards’ plan for a celeritous comment and deliberation period is the fact that over the last few months their re-exposure has, in retrograde fashion, moved closer to the original draft.  See our Lease Tips Article from July, 7^th.  Please stay tuned as we continue to follow the Boards’ deliberations.

For further details, periodically check the leases project sections of the IASB and FASB websites.

For the full press release please visit the  IFRS website.

When buildings have vacancies, or one or more tenants perform certain standard building services themselves (e.g. nightly office cleaning), the mechanism in commercial leases designed to reimburse the landlord for operating expenses can malfunction. This may cause either undercharges or overcharges to the tenant, depending on the type of lease and the year in which the drop in expenses occurs. Gross-ups are intended to counteract this problem by adjusting expenses to the level they would be in a normal, fully operational building, with the landlord providing all standard building services to all tenants.

In most commercial leases, tenants are required to reimburse their landlords for their share of building expenses.  The reimbursement mechanism operates one of two ways, depending on the form of the lease:

• “Net” leases, in which the tenant is charged a percentage (based on its share of the total building area) of total building costs each year
• “Modified gross” leases, in which expenses are built into the rent (the rent is higher) and the tenant pays for its share of increases in expenses each year over the expenses for the base year.

For a full discussion of the differences between different lease types, see KBA’s LeaseTip™ entitled “Demystifying the Difference between Net and Gross Leases.”

When parts of a building are vacant or otherwise not receiving building standard services, the landlord’s operating costs for the building are less than normal.  This situation can be problematic when trying to calculate the proper share of building expenses for those tenants in occupancy and who are actually receiving all of the building services.

Grossing Up to Prevent Understated Tenant Reimbursements

If the reduction takes place anytime in a net lease, or in a year other than the base year of a modified gross lease, the tenant will pay less than its full share of expenses.  That’s because a reduction in overall expenses dilutes the tenant’s proper share of these costs.  Each tenant’s respective share remains fixed based on its percentage of the entire building, even though its actual share (based on only those tenants receiving services) may be higher.

Of course, calculating each tenant’s share as a percentage of occupied space, rather than total building space, could potentially fix this problem.  However, it is an imperfect solution because tenants in occupancy would have to pay disproportionate shares of fixed building expenses.  For example, a tenant who occupies 25% of a building, but due to vacancies is the only tenant in occupancy, would have to pay 100% of the expenses.  Thus, this single building tenant would have to pay 100% of landlord’s insurance costs for the property.

The better solution is to adjust the expenses to levels that would be present in a fully occupied building.  Here, in a building that is only 25% occupied, the property insurance costs would remain unchanged, but the abnormally low service costs, such as cleaning expenses, would be adjusted or “grossed up” to what they would be in a fully occupied building.  Now, the vacancy has no impact on the 25% tenant’s obligations.  Such tenant pays 25% of an undiluted amount – exactly what it would have paid had the building been full.

Every commercial lease should require that expenses be fully grossed up every year.

Grossing Up to Prevent Tenant Overbillings in Base Year Leases

Grossing up is especially important in base year leases to prevent windfalls to the landlord.  In modified gross leases with base years, the tenant is required to pay for all increases in expenses over the amounts incurred during the base year (typically the first year of the lease).  The idea is to provide a mechanism to protect the landlord against increases in costs due to inflation and other similar forces.  Each year, the building expenses are compared to what they were during the base year, and the tenant pays its share (based on its percentage of the entire building) of any resultant increases.  This mechanism keeps the landlord whole as costs rise.

If costs are suppressed during the base year due to building vacancies or other reasons, the base year will be abnormally low as compared to years where no such conditions exist.  If expenses thereafter increase to “normal” levels, when each year’s expenses are compared to the suppressed base amount, the increase for which a tenant is responsible becomes exaggerated.  This causes an annual overstatement of the tenant’s liability.

For example, if during a base year only 25% of a building needs to be cleaned, and the building fills up the following year, necessitating full cleaning, the cleaning expense will rise to four times its original level, even with no increase in cleaning rates by the vendor.  The tenant who occupies the original 25% will be required to pay 25% of this quadrupled increase.

Furthermore, because the base year expenses are used to calculate the tenant’s liability each year of the lease, this overstatement will occur every year of the lease term if the building remains fully occupied.  This creates an annual windfall for the landlord at the tenant’s expense.

To correct this, the base year expenses must be grossed up to normal full occupancy levels.  The low cleaning expense would be adjusted to what it would be in a full building, as should be done every year.  Then, if there is no increase in rates, the number will remain the same.  If rates increase, the number will rise accordingly.  Grossing up the base year expenses eliminates artificial increases and causes the expenses to rise only if normal market forces cause rates to increase.

Every base year lease should make a particular point to require that base year expenses be fully grossed up.

Fixed vs. Variable Expenses

Note that not all expenses vary in direct proportion to occupancy.  Many have a fixed component—a part that is unaffected by occupancy.  For example, while cleaning expenses may be highly variable, core building costs such as insurance or HVAC and elevator system repairs will not change significantly with variations in occupancy.  Each expense must be examined closely to determine if and to what extent a gross-up adjustment of the actual expense incurred is appropriate. 

The Building Owners and Managers Association (BOMA) has developed several suggested methods and calculations that some landlords are beginning to follow.  However, a landlord’s claim that it is following BOMA does not mean that its gross-up adjustments are correct.  BOMA has three different approaches to grossing up costs, and the one chosen by the landlord may not be appropriate.  Also, even though BOMA warns landlords to consider all of the relevant factors in performing gross-up calculations, many landlords simply follow BOMA’s generic formulas and forms without considering if they make sense in the circumstances.

Grossing Up for More than Occupancy

As mentioned above, occupancy is not the only factor that causes expense levels to be unusually low.  Warranty coverage of new building systems temporarily reduces maintenance costs and must be adjusted.  Also, in cases where management fees are calculated as a percentage of revenue, free and reduced rent periods will reduce management fees and must be adjusted to full rent levels.  Again, each expense must be carefully examined to ensure that these abnormalities are addressed to keep the pass-through/escalation clause operating as intended.

Conclusion

Grossing up is a necessary adjustment that should be required as part of the operating expense (as well as tax and utilities) reimbursement mechanism of every commercial lease.  It ensures that landlords receive full reimbursement of their expenses, and that tenants do not pay more than intended.

Timing

For the better part of a year, the real estate community has been highly anticipating the pronouncement of the final standards by Q4 2011, subsequently to come into effect sometime in 2013.  Concerns surrounding the complexity of implementation have pushed the probable date back further to 2015.  However, there now is word that the Boards may take the Leases proposal down the same road as the Revenue Recognition project and re-expose the draft of the proposed new rules.  While this is not yet a certainty, a re-exposure would essentially take us back to day one and substantially elongate the implementation timeline.

One or Two Accounting Approaches for Lessees?

The Boards, after receiving many comments regarding this controversial portion of the proposal, had tentatively agreed to recognize the fact that not all leases are entered into as a financing vehicle for an asset purchase. Accordingly, they established two forms of leasing – “finance leases” and “other-than-finance” leases.  The latter, while not completely devoid of some financing element, recognized that the primary purpose of the lease is to create economic flexibility, such as to mitigate the risk of ownership and/or outsource significant activities principally related to maintenance and administration of an asset.

Perhaps the Boards felt that determining which leases were to be considered a finance-type as opposed to an other-than-finance-type was too onerous because, for whatever reason, they have reverted back to a single accounting approach for all leasing transactions.  This current approach, which is the same as the approach originally provided for in the Exposure Draft (“ED”), requires lessees to:

1. Initially recognize a liability to make lease payments and a right-of-use asset, both measured at the present value of the lease payments.
2. Subsequently measure the liability to make lease payments using the effective interest method.
3. Amortize the right-of-use asset on a systematic basis that reflects the pattern of consumption of the expected future economic benefits.

Because the liability will need to be amortized over the lease term like a mortgage loan, the annual interest expense is front-loaded, thereby requiring lessees to report higher lease expenses in the earlier lease years.

Options are In,  “More Likely Than Not” is Still Out

As previously reported, the Boards have recognized the near administrative impossibility of determining when it is “more likely than not” that an option will be exercised. To recap, the revised definition now reads:

“The lease term is the non-cancellable period for which the lessee has contracted with the lessor to lease the underlying asset, together with any options to extend or terminate the lease when there is a significant economic incentive for an entity to exercise an option to extend the lease, or for an entity not to exercise an option to terminate the lease.”

Therefore, at initial measurement and/or subsequent re-measurement, the determination as to whether a “significant economic incentive” exists will include, among other factors, the economics of the option compared to current market conditions, as well as whether significant commercially advantageous terms exist.

Reassessment

Reassessment of the lease term would only occur when there is a substantial change in relevant factors that would impact whether a lessee would have, or no longer have, a “significant economic incentive” to exercise any options to extend or terminate the lease. A lessee should take contract-based, asset-based and entity-based factors into consideration when reassessing whether a “significant economic incentive” exists.  These factors, when coupled with the tentative suggestion that in making this determination lessees should not consider changes in market rates after lease commencement, seems to suggest that the Boards are leaning toward a more subjective form of decision-making process – relying on external forces  as well as internal business decisions – as opposed to a more objective one whereby a “significant economic incentive” is measured by market forces and current pricing models (somewhat like valuing an “in the money” option).

In any event, this tentative modification to the ED would require a remeasurement of the asset/liability/income/expense in the first reporting period occurring after the “significant economic incentive” becomes apparent, notwithstanding that the lease required notice date has not yet arrived.

The Separation of Lease and Non-Lease Components

The Boards’ more definitive stance now dictates that an entity be required to identify and separately account for the lease and non-lease contract components.  Lessees are instructed to allocate payments as follows: if the purchase price of each component is observable, payments should be allocated on the basis of the relative purchase price of each distinct component; however, if purchase prices are not observable, all payments required by the contract should be accounted for as a lease.

The Boards have noted that, in consideration of the relevance of guidance in other projects such as revenue recognition, application guidance on how a lessee should determine what would constitute an observable price shall be provided.

When to Start: Inception versus Commencement

In response to questions concerning when to begin measuring lease assets and liabilities, the Boards have tentatively proposed that both lessee and lessor should recognize assets and liabilities (and derecognize any corresponding assets and liabilities) using a discount rate calculated at the date of lease commencement. The lessee should use the discount rate the lessor charges the lessee or, in the alternative, the lessee should apply its own incremental borrowing rate.

Furthermore, the Boards aim to capture Initial Direct Costs (those costs directly attributable to negotiating and arranging a lease that, but for the lease transaction, would not have been incurred) by requiring lessees to capitalize such costs by adding them to the carrying amount of the leased asset.

Lessees with leases which, at the date of commencement have a maximum possible term (including options to renew) of 12 months or less, need not recognize the lease asset or liability.  The Boards have tentatively decided that these short-term lease payments should be recognized in profit or loss on a straight-line basis over the lease term.

Looking Forward

While the ultimate decision may be a long-way off, there are sure to be more substantive changes, and changes to those changes, in the future; we will diligently keep you apprised of the path of the FASB/IASB Lease Proposal.