Forum attendees listen and learn what the lease accounting changes may have in store for their companies.

If any subject turned corporate heads at the recent IAMC Spring Professional Forum in Phoenix, it was the coming changes in lease accounting.

Say what? How could such a subject be anything but dull? "I wanted to rename this session ‘Does Artificial Grass Grow, and At What Rate?’" joked moderator Bob Zane, vice president, real estate operations, for Campbell Soup Co., and a former IAMC Chair. By the end of the session, however, reactions among the full house of corporate real estate and service provider professionals in the room ranged from a scramble for a copy of the presentation by Doug McEachern of Deloitte & Touche LLP to some variation on this statement: "I had no idea this was happening."

What’s happening is nothing less than a sea change — in this case, an overseas change — from the rule-based accounting principles behind FASB’s SFAS Rule 13 that most U.S. real estate directors are familiar with, toward a convergence with the principle-based standards of the International Accounting Standards Board in what will be known as the "International Guidance IAS 17" guideline. What the change does is effectively — very effectively — kill the operating lease as we now know it.

"Everything will be a capital lease," said McEachern, a partner with Deloitte since 1985 and its national director of real estate audit and enterprise risk services. "Operating leases will be dead, and [leases will be] on the books as a liability and as an asset."

Under FASB, in place since the 1970s, there were four criteria for a capital lease, he explained:

1. If a transfer of ownership occurred;
2. If the lease contains a bargain purchase option;
3. If the term equals 75 percent or more of the estimated useful economic life of the property;
4. If the present value of the minimum lease payments at the beginning equals or exceeds 90 percent of the fair value of the leased property.

"The 90-percent rule is the ‘most worked,’" said McEachern. "Some would say most abused, by keeping things at 89.9 percent. There was a large business in designing leases to keep them off the balance sheet. I didn’t know until last year about SIVs [structured investment vehicles]. There was a 2002 SEC report on off-balance-sheet reporting abuses, looking at SPEs [special purpose entities] and leasing. FASB was pressured to do something. The most famous attribution was the airlines — all these airplanes, and they’re not on anybody’s books."

Once the merger of standards occurs in what experts now project will be 2011 or 2012, that capital lease will become "an asset on the balance sheet that equals the present value of the minimum lease payments, and will be a liabilty that will amortize off just like any over time," said McEachern. "You’ll have interest expense and amortization of the leasehold improvement. And it enhances EBITDA. That’s what is going to happen."

As anyone who does business globally will immediately discern, international standards are not necessarily synonymous with clear standards. McEachern stressed this in pointing to the fact that there are no "bright lines" in the new standard, and that international accounting treatments have been defaulting to the bright line tests in the U.S.

"Lest anyone have a belief that international accounting standards are the same across the world, that’s not quite true," he said.

At present, the combined forces of the FASB and IASB are inching forward based on the findings of a 2000 report by the G4 +1 countries, which said lease accounting treatment should focus on the transferred rights and obligations, and that every lease is a capital lease. But while agreement in general is easy to come by, the two groups have struggled with the details, such as bargain purchase, purchase options, renewal options and establishing fair value of options.

"If there is an embedded option in a contract, from an accounting standpoint you’re required to parse that out and fair value that separately as you go forward," said McEachern. "It’s at a standstill now. The two boards are comfortable, but have no where to go. No progress has been made. At the start, they wanted a quick fix focusing only on the lessee. They may now go back to that. A quick SFAS 13 fix may be that the 90-percent test becomes a 50-percent test. They may split lessor/lessee accounting."

Among what McEachern labeled as "devil in the details" issues is the question of scope (e.g., software, intangibles) and such questions as "What happens if you have an option to extend the lease? Do you have to follow the new accounting for that?"

Though a host of questions arise from the shift, McEachern was quick to point out that "the world will not crash down. It’s just a different way of approaching financial statements." In presenting some examples of such statements, he noted the ballooning of the balance sheet, changes in the debt-to-equity ratio, initially lower net income, but higher EBITDA.

"That change is what bankers and you will need to understand," he said. "It could impact bonuses. But the point to drive home is it is going to change. How does your organization want to evaluate and deal with it today? You have three years or so. What is going to be impactful to your treasurer, CEO, CFO and board?"

George Manos, president, USS Real Estate for U.S. Steel, decided in preparing for the IAMC session to go and ask those very questions of his colleagues in finance, accounting and the CFO’s office.

"I got a wide variety of response," he told the audience, "from ‘This is SOX [Sarbanes Oxley] all over again and we are in deep trouble’ to ‘Don’t worry about it.’"

Thus the prescription for the corporate folks in the room was clear: Do some similar talking with your own colleagues, and clarify relationships with banks and other financial institutions. Much also depends on the risk-taking or risk-averse culture of a given company. And much also depends on how those executive bonuses on the top floor may be affected by altered calculations.

Among possible concerns to scrutinize is how far out to take appraisals, recording of revenue on the lessor side and tax compliance.

Among the action steps Manos and his colleagues are taking at U.S. Steel is to look at its entire portfolio (as both lessee and lessor) as if the coming changes were effective on January 1, 2008. Such an exercise can at least be a guideline for establishing thresholds, and for evaluating companies that may be seeking to lease from your organization.

"Go in and practice a little, and see what your shop looks like," Manos advise the IAMC audience, by now most decidedly awakened to the coming new realities of their leased portfolios.

Many attendees were caught off guard that lease accounting reform would be so radical.

In the Q&A that followed, befitting the nature of the topic, there were a plenty of "Q"s, and a smattering of "A"s. What emerged were some things to think about — or, in some cases, rethink.

"I’m somewhat guilty of thinking that leases are pretty generic," McEachern said. "I’ve come to discover that they aren’t. It’s very painful to read those leases and understand what some of the terms are. There are probably two pages in a 150-page document that are of concern with accounting. There is a whole series of things we’re getting a lot better at in reading."

No doubt he and his colleagues will be interested, for instance, in the new industrial lease clause authored by IAMC that will make its premiere later this year.

Manos said the new standards do nothing to change the fact that facility project decisions still come down to making the best business sense. And McEachern noted that the changes will happen to everyone’s company at the same time: "It could be somebody has a massive amount of leases and takes 15 to 20 years to flush them out of the books," he said.

Synthetic leases? "I’d imagine they’d be deemed capital leases, put on the books, and just move on," said McEachern. Options over a fixed period of time will be present valued. As for subleases, he said, "The sublessee will have the present value of the payments and put it on the books and go forward. The lessee who now is a lessor will look at the asset he’s going to be receiving, and may have a loss on the books. That exists today."

"Will this pressure users to shorten terms and take the risk of future increases in value?" asked one IAMC attendee.

"From a user standpoint, most of the time, clients want certainty over a period of time, as opposed to speculating on what the value will be two to three years out," responded McEachern. "If the term is two to three years, with 15 five-year options, somebody will come back and say, ‘Wait a minute. What are we really doing here?’"

"With the conversion, is it the expectation that credit agencies will take it into account and re-evaluate issues regarding debt?" asked another audience member.

"They’re looking at that," said McEachern. "It will change ratios, but not cash flow."

"That goes back to that relationship thing," added Manos. "Go to those financial people now and ask them. Three have said, ‘We may have to modify things.’ The fourth said, ‘What changes?’ That scared us, and so we’re doing some other things with that fourth."

What about those who carry large inventories, and avoid the balance sheet by switching to 3PLs (third-party logistics providers)?

"The person taking that risk, owning that space, will have a contractual agreement with the provider," said McEachern. "They’re going to have a lease. There is a scope issue, as there are leased employees with some of these companies."

Finally, asked one more attendee, are they contemplating fair market value on owned real estate?

"I deal with REITs and pension funds, and their accounting is at fair market value," said McEachern. "For investment real estate, the expectation is that it will be fair market value shortly. Whether you have to fair value leases as opposed to just put them on the books, then fair value of operating properties and manufacturing facilities you own, I don’t know that they look at that as fair value by owner. It’s conceivable in two to three years. In Europe, 70 percent of companies use a fair value reporting mechanism, and disclose what the fair value is."

Amid the swirl of questions, Manos told a story that got to the heart of the communication and strategy issues central to this shift. The story goes that one of the old steamship lines was looking to hire a Morse code operator. An applicant showed up at the appointment time at the company’s busy New York offices, waited about 20 minutes and nothing happened. Somebody else showed up, waited about 30 seconds, then went through a door, sat down and got the job.

"The Morse code above all the noise was saying, ‘The first one through that door gets the job," said Manos. So the question about lease accounting changes he posed to the audience was this: "What are we all listening for above that noise?"

The sound may be faint now. But giving it the proper attention today may keep it from becoming a roar in the long term.