Facilities managers have a diverse range of ongoing challenges to manage. These include service performance standards, lease renewals, relocations and consolidations, workplace churn, green initiatives, new premises roll-out, and various capital projects. Now the spectre of new complex lease reporting standards is on the horizon. Although most facilities managers understand the necessity to stay in tune with the needs and priorities of the CFO (chief financial officer), these impending lease reporting requirements are likely to herald an even more cosy relationship in the future.

All organisations need premises from which to operate. In most cases the use of premises is secured by entering into lease agreements with landlords. In this arrangement, organisations secure premises from which to conduct their operations without having to commit working capital to build and own buildings – and landlords secure rental income to underpin their property investment.

For tenants this symbiotic relationship provides ‘off balance sheet’ funding that does not reflect the full extent of their future lease liabilities. This lack of transparency is now about to change with the Australia Accounting Standards Board (AASB) having issued as exposure draft – ED 202 Leases – aligned with international accounting trends. The objective is to require more transparency of lease liabilities in Statements of Financial Position. And this new transparency is likely to change behaviours and decisions related to leasing strategies.

REPORTING CHANGES

The fundamental change to the lease reporting standards is the proposed scrapping of the simple concept of accounting for lease payments as ‘rent expenses’. Instead, in the operating statement, all leases will now be recognised as ‘right of use’ assets with corresponding obligation for the interest charge to amortise these non-recurrent assets as lease liabilities. In Statements of Financial Position there will now be an entry recognising the liability for the present value of total rentals payable for the lease term (deemed to be the ‘longest possible lease term that is more likely than not to occur’) with a corresponding non-current asset representing the ‘right of use’ for the premises based on the present value of lease payments (plus transaction costs less some operating costs). With this approach, in the future, all currently classified operating leases are likely to reflect the current treatment of finance leases with all financial obligations reported. The current practice of assessing whether the risks and rewards of a leased property asset have passed to the tenant to determine the distinction between these two forms of leases will no longer be relevant.

ASSESSMENTS TO BE MADE
In the process of preparing for the lease reporting, facilities managers are likely to spend more time with their CFOs and auditors in determining judgments that will likely have financial reporting implications, as well as assessing the appropriateness of future leasing strategies and transaction decisions. For fixed-term leases with no options, determining the carrying amount for each lease liability and the ‘right of use’ asset value is likely to be relatively simple. However, where leases have renewal options and contraction clauses, the process is likely to be more challenging. A judgment on the probability of exercising these rights in the future will be needed to determine the ‘longest possible term that is more likely than not to occur’ as set out in ED 202. This process will require subjective judgment. And this may be driven by the CFO, facilities manager or business unit leader, dependent on business priorities – always recognising that the longer the estimated lease term, the greater the lease liability to be reported. Another subjective element affecting the initial ‘carrying value’ of the lease liability and the ‘right to use’ asset will be the estimation of contingent rents such as turnover rentals and escalation rates, requiring the estimation of the expected business growth, market rentals and CPI escalations. These subjective judgments will need to be repeated at each financial reporting period.

Another intriguing aspect is the discount rate to be applied to the future lease payments in determining the lease ‘carrying values’. The standard directs that this be either the property discount rate being charged by the landlord, or, if unavailable, the tenant’s incremental cost of borrowing. Different companies with identical leases may have different accounting outcomes simply because one has a higher cost of borrowing than the other. This means that less creditworthy companies with higher costs of borrowing will have smaller financial impacts on their balance sheets than more stable companies – from the same lease structure!

CHANGES IN BEHAVIOUR
Tenants will likely have to consider and deal with the possible impact on a range of business and financial measures and change their operations accordingly. Tenants will now need to account for their lease premises both as an asset and an obligation on the Statement of Financial Position. This is likely to introduce a range of complexities to a previously relatively simple subject. There are likely to be wider issues to address that affect the business operating model other than just the compliance requirements of the reporting requirements. The possible impacts that facilities managers will need to be discussing with the business leaders and CFO are likely to include the following:

• rent will disappear, to be replaced with interest and amortisation charges, in financial terms. EBITDA and cashflow from operations are likely to increase with accommodation leasing now seen as a financing activity under the control of the CFO;
• net operating income and distributable profits are likely to reduce in the earlier years of lease agreements with ‘front-ending’ of the lease expenses and lower finance charges over time. This approach contrasts significantly to the current straight-line charging of operating lease payments over the life of the lease. The implications of this short-term profit reduction are likely to become the focus of the management leadership group;
• in addition, this reduced net operating income in the early years is likely to necessitate increased short-term internal accommodation chargebacks. This change is likely to affect performance measures, profit-related payments and executive performance metrics, which may need to be changed;
• financial ratios will be affected with potential changes to debt/equityratios, interest coverage ratios and loan covenants. The introduction of interest charges on the lease ‘carrying values’ in the statement of financial position is likely to attract the attention of debt and equity funding providers;
• In the future all leases currently classified as operating leases will be accounted for in the same way as finance leases, bringing an end to the availability of the most common form of ‘off-balance sheet’ finance via landlord leases currently used by companies. And not being able to avoid having to report lease obligations on the Statement of Financial Position, the re-emergence of complex financing property development leasing structures is expected;
• portfolio leasing strategies may change. Shorter leases to reduce lease interest costs may become realistic considerations for tenants – knowing the longer the lease the greater the impact, particularly on those tenants under financial pressures. In turn, this may affect the property market dynamics with increased market uncertainty, reduced tenant incentives being offered, and even the inability to develop pre-commitment leased properties because of the shortness of the lease terms;
• potentially there may be a renewed focus on the ownership of accommodation assets, rather than relying on leasing arrangements. With the new reporting standards, the balance of the financial impact between own versus lease options are less likely to be differentiation features in these decisions;
• the possibility of categorising part of the lease payment, substantiallybeing the building ‘outgoings’, may entrench the trend to net lease payment structures. But these services, exempt from these new reporting standards, may see the emergence of separate accommodation service agreements with separate payment structures and performance standards. But this may be too great a challenge to be assimilated by the property industry;
• to manage the annual reporting requirements for large portfolios, new processes and mechanisms may need to be implemented to consistently determine renewal probabilities and contingent rental provisions;
• undoubtedly, lease information tracking related to option and renewal dates, with a focus on validating current lease data integrity, is likely to become a more critical part of facilities managers’ duties.

The earliest mandatory adoption date for these new leases reporting standards is likely to be during 2013, and some transitional provisions are likely to facilitate implementation. However, commentators appear to feel that with few exceptions, the final standard is expected to be adopted largely as proposed. With no ‘grandfathering’ provisions for existing leases, the financial impact of multiple existing leases (and leases currently being negotiated) may be significant. Once adopted, prior year leasing decisions may manifest a range of unintended consequences. For facilities managers there is still time to get to understand the implications of these new reporting standards in current lease negotiations. But now is the time to learn more about the accounting implications of the new standards and to cosy up to your CFO.