What is the catalyst behind the proposed changes?

1. The Changing Landscape of Lease AccountingA joint IASB/FASB projectAlvin WadeAudit PartnerMay 26, 2011

2. What is the catalyst behind the proposed changes? • The Sarbanes-Oxley Act required the SEC to do a study of off-balance sheet transactions. • Lessee off-balance sheet operating leases were cited as a major financial reporting deficiency. • The FASB and the International Accounting Standards Board (IASB) have formed a joint project to converge world-wide accounting rules (including lease accounting).

3. What is the primary objective of the proposed changes? • To require all leases to be recognized on the balance sheet of lessees and lessors

4. Originally proposed impact on the lessee • Required to record an asset representing the right to use the asset over the lease term • Record a liability for the obligation to pay rentals • The recorded asset and liability require the lessee to estimate certain future events and conditions such as renewal options, contingent rents and incremental borrowing rate

5. Types of arrangements scoped out include: • Leases of intangible assets • Leases to explore for or use natural resources • Leases of biological assets • Contracts that represent the purchase or sale of the underlying asset

6. Changes to proposed ED • Based on nearly 800 comment letters – the boards re-deliberated the following: • Lease term • Variable lease payments • Income and expense recognition pattern • Lease definition

7. Definition of lease term • Originally proposed • The longest possible lease term that is more likely than not to occur (greater than 50%) • Currently proposed • The non-cancellable period, plus any options where there is a significant economic incentive to extend

8. Economic incentives • Cancellation penalties for non-renewals • Bargain purchase price • Significant installation costs (i.e. customized tenant improvements)

9. Variable lease payments (contingent rents, termination penalties) • Originally proposed • Amounts were to be estimated under various scenarios and included as part of your assets and liabilities recognized • Currently proposed • Higher recognition threshold established to include certain performance based contingent rents in definition of lease payments

10. Income and expense recognition pattern • Originally proposed • Front end loaded expense and income recognition • Currently proposed • No change – consideration was being given to allowing straight line recognition of lease income and expense for leases not having a significant financing element.

11. Comparison of current treatment to the proposed standard A simple example: • Lease Term - 5 years, annual rent is $20,000 per year • Lessee's incremental borrowing rate = 8%

12. Comparison of current treatment to the proposed standard (continued) A simple example:

13. Comparison of current treatment to the proposed standard (continued) • Front ends lease expense as straight-line depreciation and imputed interest replace straight line rent.

14. Proposed standard requires estimate of lease term and payments • Renewal options • Contingent rents • Incremental borrowing rate

15. Renewal options/contingent rents Base term (years 1-5) $20,000 + 2% of sales First renewal (years 6-10) $25,000 + 2% of sales Second renewal (years 11-15) $30,000 + 2% of sales IBR-8%

16. Assume: -Will exercise only first renewal -Contingent rents = $500 year 1 and grow $20/year

17. Business implications of proposed model • Impact on loan covenants and financial ratios • debt to equity ratios • interest coverage • Impact on buy vs. lease decisions • Impact on standard lease terms (may want shorter leases) • Tenants may want to renegotiate existing long-term leases

18. Impact on landlord (lessor) • Required to recognize leases on their balance sheet • Desire symmetry between lessor and lessee • Several approaches being considered • Performance obligation approach • Derecognition approach • Hybrid model

19. Performance obligation • Lessor records lease receivable based on estimated lease term and contingent rents received • Payments discounted using implicit interest rate in the lease • Interest income recognized on the effective interest method • Liability recorded for obligation to provide the use of the space and amortized over life of the lease

20. Comparison of current treatment to the proposed standard A simple example: • Lease Term - 5 years, annual rent is $20,000 per year • Implicit interest rate = 8%

21. Comparison of current treatment to the proposed standard A simple example:

22. Derecognition model • Lessor would partially derecognize the underlying asset • Residual interest in investment property and lease receivable will be recorded to the B/S as separate assets

23. Status of proposed project • Boards continue to deliberate final revisions to the proposed standard • Changes needed to lessor accounting will be considered as a separate project or later as part of this project • Final standard still targeted for 2011

24. Questions

25. The New Lease Accounting Standards The Real Estate Perspective

26. The New Standards (as of April 21, 2011) A Brief Overview Key differences • No More Operating Leases • Balance Sheet Impact • FAS 13: Operating Lease – It is off the balance sheet • FAS 13: Capital Lease – On balance sheet • New Standard: All leases on balance sheet, and impact for some leases is larger than under FAS 13 Capital Lease. • Renewal Options – If “significant economic incentive” • Contingent Rents – If “disguised” • “Short term” leases not capitalized (but active debate at May meeting)

27. The New Standards (as of May 20, 2011) A Brief Overview Key differences • Income Statement Impact • FAS 13: Operating Lease – Straight line rent over term • FAS 13: Capital Lease – Amortization of asset (PV of rent at lessee’s incremental borrowing rate) + Interest expense on remaining liability. • New Standard: • Boards Must Like The Texas Two-Step … • To know what’s happening you need a calendar

28. The New Standards (as of May 20, 2011) A Brief Overview Key differences • Income Statement Impact • August 2010: • Exposure Draft – • All leases the same • Amortization + Interest; Front Loaded P&L profile • April 2011: • Revised Proposal Approved by Boards: 2 kinds of leases: • “Finance Lease” – ED Method • “Other Than Finance Lease” – Calculated on straight line with interest component, but presented as “rent expense” on P&L • May 19, 2011: • Boards agree to reverse course – back to ED Method / no classification

29. The New Standards (as of May 20, 2011) A Brief Overview Key differences - Options • Renewal & Termination Options Included In Calculations: • FAS 13: “Reasonably assured” = rarely triggered • New Standards: • Original Exposure Draft : “More likely than not” • Revised Proposal: Include if “Reasonably certain” based on the presence of a “significant economic incentive” to renew or terminate • … so much for objective criteria … • Is 95% of FMV renewal a “clear economic incentive”? • High value T.I.s with remaining life would be though • Critical / strategic business use for space • Easier to trigger for Lab, Manufacturing, SCIF and custom space

30. The New Standards (as of April 21, 2011) A Brief Overview Key differences – Contingent Rents • Contingent Rents Included In Calculations: • FAS 13: CPI, Yes; Other Contingent Rents, No. • New Standards: • Original Exposure Draft: All included based upon probability weighted outcomes (a.k.a. the crystal ball method) • Revised Proposal: • CPI based on “spot” rate as opposed to probable • Percentage Rent • Only if “disguised minimum rent” • Based on expected outcome / estimate

31. The New Standards (as of May 20, 2011) A Brief Overview Key differences – Executory Costs • Executory Costs: • FAS 13: All are excluded for both capital and operating • New Standards: • Original Exposure Draft: Executory costs replaced with “Distinct Service Components”, not same as Executory Costs • “Distinct service components” not capitalized as asset / liability • Non-distinct service components – notably property taxes and insurance – to be capitalized • Revised Proposal: • Separate “lease” and “non-lease” components • Not via Rev. Rec. / “Distinct Service Components” • “Observable prices”

32. New Lease Accounting Rules Executory / Non-Lease Components • Combo of Front Loaded P&L + Executory / Non-Lease • Revised proposals make current and future executory treatment the same • Effect on tenants with gross leases • Most have not removed base expenses from FAS 13 rent • Constant base amounts and straight line rent have same P&L. • Not the case with new standards due to front loading. • Impact: More work / calculations to avoid overstating asset and liability. • Creates added incentive for tenant to ensure base year costs are as high as possible because: • Reduces add’l rent expense, • Keeps more $ off balance sheet

33. Specific Issues To Address Determining the Term: “Significant Economic Incentives”

34. New Lease Accounting Rules Impact of Renewal / Termination Options • The Case of One Lease • Key Assumptions For Exercise: • 100,000 RSF • Tenant’s Incremental Borrowing Rate – 7.0% • 10 Year Term, with one 10 Year Renewal Option • Rental Payments / Year / RSF • Include taxes + insurance, exclude “Distinct Service Components” • Annual Rent • Years 1 – 3: $40 / RSF • Years 4 – 6: $45 / RSF • Years 7 – 10: $50 / RSF • Renewal: FMV but not less than $50 / RSF

35. New Lease Accounting Rules Impact of Renewal / Termination Options • Renewal Options • Determining “significant economic incentive”. • Are renewal options truly exercised in most cases? • To what extent will income statement sensitivity drive renewal decisions? • Need auditable process / mechanism by which renewal “decisions” can be tested. • Second guessing of renewal determination by competing interests • A few “what if?” examples:

36. New Lease Accounting Rules Impact of Renewal / Termination Options Baseline Scenarios #1: No Signficant Economic Incentive

37. New Lease Accounting Rules Impact of Renewal / Termination Options Baseline Scenario #2: “Significant Economic Incentive” Exists

38. New Lease Accounting Rules Impact of Renewal / Termination Options Baseline Scenario #3: No “Significant Economic Incentive”, Lease Renewed

39. Real World Consequences Forget Baseline: What Happens When … … No Incentive At LCD, But At End of Year 5 Incentive Materializes?

40. Real World Consequences Forget Baseline: What Happens When …? Impact of Decision: Immediate Losses, Aggregate “Wash”, NPV is Loss

41. New Lease Accounting Rules Example Of Unintended Consequences Impact On Lease Negotiations – Death of “Blend & Extend” Deals?

42. Transitioning To New Standard How, When & Who

43. New Lease Accounting Rules Transitioning Existing Leases: Sample Calcs

44. New Lease Accounting Rules Transitioning Existing Leases: Sample Calcs P&L – FAS 13 vs. New Standard

45. New Lease Accounting Rules Transitioning Existing Leases: Sample Calcs Cash Flows Remain The Same

46. New Lease Accounting Rules Transitioning Existing Leases: Sample Calcs Balance Sheet Impact

47. Implementation Challenges Transition vs. New Deals vs. Monitoring

48. Implementation Challenges Transition vs. New Deals vs. Monitoring • AN AUDITABLE PROCESS IS REQUIRED • Sarbanes Oxley – who will sign off on subjective decision? • Consistent practice across company’s lease portfolio • Subjective nature of decisions needs objective support • Term – Renewal and Termination Options • Contingent Rents • Incremental borrowing rate • Initial direct costs • Non-Lease Components / Observable Costs • Process / calculations / decisions revisited as circumstances change. • Outside assistance / resources

49. Implementation Challenges Transition Planning • Its sooner than most realize • Lead time to gather necessary information and documents • Lead time to institute corporate process / standardization • Dual Standards between now and Effective Date • Multiple stakeholders • Legal, risk and compliance issues • ERP Financial reporting systems

50. Implementation Challenges Transition Planning • “Date of Initial Application” (DIA) • Effective Date is “transition” date, but need to report based on new standard sooner, based upon comparative financial statement requirements of lessee • Determining Your DIA • If Effective Date is 1/1/15 companies providing comparative financial statements: • 5 years = DIA of 2011 • 4 years = DIA of 2012 • 3 years = DIA of 2013 • Which leases to include • All leases in effect on the first day of the lessee’s DIA • All leases executed between DIA and Effective Date