Financial Accounting Standards Research Initiative

I am a consultaant to the leasing industry and I recently did a web cast for FASRI on the lease accounting project. For those who know the lease project details, lessees will no longer report rent as an expense, rather they will report front ended lease costs comprised of imputed expense on the capitalized lease obligation and straight line amortization of the capitalized lease asset. In addition far more will be capitalized than what Moody’s & S&P capitalize in their credit analysis. Few people have gotten into the details of this project and of course the devil is in the details.
Brace yourself for the impact which I will partially explain below.
I met with a major US money center bank to explain the impact of the proposed lease rules on them as a lessee of commercial real estate and office space. We did a PV of the rents reported in their 10K footnote and it showed the following:

There will be additional lease assets and liabilities of $7bn

Lease costs in the year of implementation will be higher than current GAAP by $127mil

The cumulative amount of non cash higher lease costs will grow to $319mil

The cumulative deferred tax asset will be $128mil

We reviewed their common lease terms and found that they have CPI based contingent rents and they have non-bargain renewal options that they think will cause the impact to be double the above numbers. The numbers will also grow as they do intend to continue to lease space for branches and offices. They will reach a steady state where new leases replace old leases but that is likely to occur 7 or 8 years in the future.

Their regulatory and tax people said that they have reached their regulatory limit of $25mil in deferred tax assets that are allowed to get normal 8% capital allocated. Since they and most other big US banks are over their limit, very dollar of the deferred tax assets created by the front ended lease expense pattern (lessees will no longer report the straight line average rent as expense) will require them to post capital at 100%.

The lease project will create an estimated capital need that will peak over the next 8 years as follows, assuming double the above numbers:

ROU asset ($14bn x 8%) $1,120mil
Cumulative after tax increased lease expense thru turnaround year 383mil
Cumulative deferred tax asset thru turnaround year 256mil
Capital requirement under proposed rules $1,759mil

If the direction of the proposed rules is changed to keep current GAAP for contingent rents and renewals and if the ROU asset is amortized at the same rate as the capitalized lease obligation the capital requirement would only be 8% of the ROU asset of $7bn or $560mil.

We modeled an office space lease with a 16 year non cancelable term and two 5 year FMV renewal options. The rents escalated every few years. We did not factor in the CPI contingent rent. When we ran the 16 year term the increased non cash lease cost in the first year was 17% higher than current GAAP. Amazingly when we added 10 years of renewals the first year increased cost was 40% higher than current GAAP. I fail to understand why the costs in year 26 are accelerated so that they increase the recognized costs in year one of the lease term – if we had factored in CPI contingent rents the distortion would have been greater – again why is current P&L impacted for the possible CPI contingent rent in year 26 of the lease? An interesting point in the 26 year model is that there is negative amortization in the first 5 years where imputed interest is higher than the cash paid for rent!

If anyone is interested in any of my models let me know. A few months ago I developed a model for a retail real estate lease and the numbers were even more exaggerated as that industry is also subject to contingent rents based on sales.

We did not discuss the negative impact of grossing up leveraged leases (another capital requirement – although the regulators do realize that the only risk asset in a leveraged lease is the net investment so they may get relief there) on banks or the performance obligation method which adds depreciation expense from an asset that is a revenue producing investment and not a use asset. The negative lessor impacts will only make the impact worse for banks.

Bill,

Thanks for the analysis. I was struggling to understand the negative amortization in your 26 year example. I am guessing this occurs because you are assuming some non-trivial rent escalations, which causes the payments in later years to be much larger than the rental payments in the early years of the lease.

If this were a 26 year lease with no renewals, I think we would see a smaller difference between rent expense under right of use (ROU) and rent expense under operating lease treatment, right? Under current GAAP, rent expense is greater than the current-period cash rental payment if contractual increases are scheduled in the rental payments. I believe the total cash to be paid over the life of the lease is straight-lined. Thus, if you question why the events in year 26 should cause year 1 rent expense under the proposed model to be higher than cash paid for rent in year 1, then I think you should have the same question with regard to current GAAP’s treatment of escalating payments (assuming a 26 year lease term).

But in your example, the lease term was 16 years with 2 optional 5 year renewals. If my speculations above are right, then the optionality of the renewals is vital to produce the large differences between current and proposed GAAP that you report. I agree that recognizing the assets and liabilities from exercising an option at the origination date of the option based on expected outcomes is a big divergence from existing GAAP for most transactions (bargain renewal or purchase options in leases are obvious exceptions).

To me, booking the asset and liability now from a possible exercise of a renewal option is not all that different from booking offsetting assets and liabilities for unexecuted purchase or sales contracts or booking assets and liabilities when an employee signs a one-year labor contract. I suspect that the Boards will have a very difficult time drawing the line between what sorts of options get rolled into a lease and therefore capitalized versus what sort of options are not leases and therefore are not recognized.

Bob