Issue 1, September 2011 Spotlight Accounting Changes Are Imminent for Lessors of Real Estate

In This Issue: • Proposed Changes to and Investment Accounting • Challenges for Real Estate Companies • Thinking Ahead

The Bottom Line • In August 2010, the IASB and FASB (the “boards”) issued an exposure draft (ED) that would fundamentally change the accounting for lease arrangements. The boards have made significant changes to the proposals in the ED and have recently decided to reexpose the proposed guidance for comment. • Recently, the boards tentatively decided that a single lessor accounting model — the receivable and residual method — should apply to all except (1) short-term leases (defined as leases that have a maximum possible lease term, including options to renew, of 12 months or less) and (2) leases of investment property measured at fair value. • The receivable and residual method is similar to the derecognition model proposed in the ED. • The FASB has also been working on an investment property standard that would require certain entities to measure their real estate investments at fair value, with changes in fair value reflected in net income. Real estate companies that meet the FASB’s proposed definition of an “investment property entity” would be outside the scope of the new lease accounting standard and would most likely recognize rental income as it is contractually due throughout the lease term. • The FASB has decided that only investment property entities (as defined by the FASB) may measure investment property at fair value. This entity-based scope differs from the asset-based scope of the international investment property accounting standards. • The boards are expected to release both EDs in 2011. Neither standard is expected to have an effective date earlier than 2015. Beyond the Bottom Line Whether real estate companies are required to apply the new lease accounting standard or an investment property standard, big changes lie ahead for such companies. Real estate companies should continue to monitor the boards’ tentative decisions and prepare to comment on the lease accounting and investment property EDs. To effectively plan for the significant changes ahead, real estate companies will need to evaluate how the final standards will affect their businesses and begin to assess the requirements of an eventual implementation. The discussion below provides insight on these and other important considerations related to the proposed changes in accounting for real estate investments. Proposed Changes to Lease and Investment Property Accounting Key proposed accounting changes related to the lease and investment property projects that affect real estate companies are summarized below. Lease Accounting Project On the basis of feedback received from comment letters, roundtables, and outreach sessions, the boards have made many significant changes to the proposals in the ED and therefore have decided to reexpose the proposed lease accounting guidance for Whether real estate comment. A final standard is expected to be issued in mid to late 2012. companies are The boards have not discussed a potential effective date for the final lease standard. However, given the current time line, it has become more likely that the effective date required to apply the could be 2016, particularly when the current transition requirements, which mandate a new lease accounting form of retrospective adoption, are taken into account. standard or an Lease Term — Accounting for Renewal Options The ED proposed that the lease term be measured as the “longest possible term that is investment property more likely than not to occur,” including options to renew. Comment letters expressed standard, big almost unanimous opposition to this measurement method. The boards agreed with many of the concerns raised in the comment letters and tentatively decided on the use of changes lie ahead for a higher threshold to define the lease term. such companies. The proposed language would require the lease term to be the noncancelable period plus any renewal periods for which there is a significant economic incentive for the lessee to exercise the renewal option. These criteria would be generally similar to the current guidance real estate companies use today to evaluate renewal periods and lease term. The boards have decided to require reassessment of the lease term when the relevant factors significantly change.

The requirement to reassess the lease term may represent a challenge for many real estate companies. Such companies would need to either perform a continual reassessment or establish a robust list of “renewal indicators.” We expect the boards to receive considerable feedback on this decision.

Lease Payments The ED required the use of a probability-weighted expected outcome approach to estimate lease payments, including contingent rentals. Many real estate companies objected to this proposal, observing that the approach could add significant earnings volatility and would be costly to implement. In a departure from the ED’s proposals, the boards tentatively concluded that the initial measurement of lease payments should only include those variable payments (1) based on an index or rate (e.g., consumer price index) or (2) that are in-substance fixed lease payments (e.g., the lease contains disguised fixed lease payments). The boards tentatively decided that entities should use the spot rate to measure variable

2 payments based on an index or rate and that variable lease payments should be reassessed by using the index or rate that exists at the end of each reporting period.

This change would decrease the subjectivity and complexity of the proposed rules for real estate lessees and lessors because many types of contingent rent would be excluded from computation of estimated lease payments (e.g., overage rent and percentage rent). Despite the tentative decision, many board members still believe that contingent lease payments should be included in the initial measurement of lease payments. Accordingly, this provision may be revisited (again) during future deliberations.

Contracts With Service Elements Under the ED, when a contract contains both lease and service elements, only distinct services would have been bifurcated and accounted for separately. Nondistinct elements would have been accounted for as part of the lease contract. Distinct services were defined as services sold separately or that could be sold separately because they have a distinct function and a distinct profit margin. Many real estate leases include service elements, such as tenant reimbursements of common area maintenance, , and taxes. Respondents to the ED expressed some uncertainty about whether these service elements were distinct or nondistinct. In an attempt to eliminate such uncertainty, the boards tentatively decided that all service components included in a lease should be bifurcated and accounted for separately. The boards have Lessors and lessees will now need to allocate payments between lease components and tentatively decided service components. Generally, this allocation would be based on the relative stand-alone selling prices of the lease components and service components. that a single lessor Although a requirement to bifurcate and separately account for all service accounting model — components creates additional complexity in the lease accounting model, many the receivable and believe this is a favorable decision because it promotes consistency and comparability. Lessees also favor this decision because it reduces the amount of lease payments residual method — used to measure the lease liabilities recorded on their balance sheet. should apply to all leases. The Single Lessor Accounting Model The ED included two accounting models for lessors — the performance obligation approach and the derecognition approach. Deciding which model to apply depended on whether the lessor continued to be exposed to the significant risks and benefits associated with the underlying leased asset. A lessor that retained exposure to significant risks or benefits associated with the underlying asset would apply the performance obligation approach; otherwise, it would apply the derecognition approach. Most real estate lessors were expecting to apply the performance obligation approach to account for their leases. After further redeliberations, the boards ultimately decided that a single lessor accounting model — the receivable and residual method — should apply to all leases. The only exceptions would be short-term leases and leases of investment property measured at fair value. Under the receivable and residual method, a lessor would derecognize the underlying asset and recognize: • A lease receivable measured as the present value of the future lease payments. • A residual asset measured on an allocated-cost basis.

3 If profit on the right-of-use asset transferred to the lessee is reasonably assured, the lessor would recognize that profit as of the date of the commencement of the lease. The profit would be measured as the difference between (1) the carrying amount of the underlying asset and (2) the sum of the initial measurement of the right to receive lease payments and the residual asset. If profit on the right-of-use asset transferred to the lessee is not reasonably assured, the lessor would recognize that profit over the lease term.

We believe that the lessor model will require significant consideration during the comment period and redeliberations. The boards have struggled to develop a single lessor model that is conceptually consistent with the lessee model and that is acceptable to both the boards and their constituents. Many have stated that they did not believe that the current lessor accounting model was “broken” and have questioned whether the costs of implementing the new model were accompanied by an improvement in financial reporting. For entities that preferred current operating lease accounting, this is not a favorable decision. Many real estate companies are therefore closely following the scope and development of the FASB’s investment property project as a means of potentially avoiding the receivable and residual lessor accounting model. Many real estate companies appear to prefer a fair value measurement model to the accounting being prescribed as part of the new lease standard. Real estate companies that meet Investment Property Project the FASB’s proposed In an effort to more closely align U.S. GAAP with international standards and to increase the comparability of measurement and presentation in real estate operations under GAAP, definition of an the FASB has been working on developing an investment property standard. investment property The FASB has tentatively decided to limit the scope of its investment property standard to only those entities that meet the definition of an investment property entity (as entity will not need defined below). The scope of the investment property standard would therefore differ from the scope of the international standard, IAS 40, Investment Property, which is asset to apply the new based. Real estate companies that meet the FASB’s proposed definition of an investment lessor accounting property entity will not need to apply the new lessor accounting model to account for their real estate investments. The FASB has also tentatively decided to make fair value model to account for measurement a requirement for investment property entities. This guidance differs from their real estate that under IAS 40, which provides a fair value option and not a requirement. investments. The FASB started the investment property project as an attempt to converge U.S. GAAP with international standards. Respondents may question why the FASB would propose an accounting standard whose scope differs significantly from that of IAS 40. Although the IASB has previously indicated that it would consider amending IAS 40 to require fair value measurement of investment property, it has not indicated that it is considering limiting the scope of IAS 40 to apply only to “investment property entities.” Some international entities that have elected to measure their real estate investments at fair value under IAS 40 would not be able to do so under the FASB’s investment property entity definition (e.g., insurance companies with real estate investments). The FASB and IASB may receive pressure to work together to provide a converged standard in this area.

4 Definition of an Investment Property Entity The FASB has tentatively decided an entity is an investment property entity if it meets all of the following criteria:1 1. Nature of the Business Activities. The entity’s primary business activities relate to investing in real estate . 2. Express Business Purpose. The express business purpose of the entity is to invest in real estate properties for total return including an objective to realize capital appreciation, for example, through disposal of its real estate properties. The entity does not hold real estate properties for any of the following purposes: a. Use in the production or supply of goods or services or for administrative purposes b. Rental income only c. Sale in the ordinary course of business. 3. Unit Ownership. Ownership in the entity is represented by units of investments, such as shares of stock or partnership interests, to which proportionate shares of net assets can be attributed. 4. Pooling of Funds. The funds of the entity’s investors are pooled to avail the investors of professional investment management. The entity has investors who are unrelated to the parent (if any), and in aggregate hold a significant ownership interest in the entity. 5. Reporting Entity. The entity conducts its activities and reports financial information about those activities to its investors. The entity can be, but does not need to be, a legal entity. The Board subsequently decided to remove the restriction that investment property The FASB’s tentative entities cannot own real estate properties for “rental income only.” decisions have been The FASB has modeled its investment property entity definition on the current significant regarding definition of an investment company under U.S. GAAP. The significance of operations related to noninvestment property must be evaluated to determine whether an entity measurement for is an investment property entity, an investment company, or an operating company. real estate entities The FASB has implied that to meet the express business purpose criterion (described above), investment property entities would need to have an exit strategy for and have included how they plan to exit or dispose of their real estate investments to realize capital appreciation. The FASB has instructed its staff to provide examples or implementation proposed guidance on what constitutes an exit strategy. This could affect real estate companies requirements and that do not have any express plans to sell or dispose of their real estate assets but rather plan to realize capital appreciation through other means (i.e., entities that impacts of fair value expect to realize capital appreciation through loan proceeds for which the real estate reporting. serves as collateral).

Measurement The FASB’s tentative decisions regarding measurement of investment property by investment property entities will have a significant impact on fair value reporting for some real estate companies. To date, the FASB has tentatively decided that: • Real estate investment property will be measured at fair value with all changes in fair value recognized in net income. • Noninvestment properties will be measured in accordance with other U.S. GAAP (e.g., headquarters buildings will be measured at historical cost and depreciated). • Investment properties that are under construction will have to follow the fair value measurement guidance in ASC 820, Fair Value Measurement. This requirement differs from the guidance in IAS 40, which provides a practicability exception for investment properties under construction. • Right-of-use assets related to investment properties will be measured at fair value (e.g., ground leases for which the investment property entity is a lessee). • Rental revenue on investment properties will be recognized as it is contractually due throughout the lease term.

1 Criteria are as outlined in the FASB’s Summary of Decisions Reached to Date (as of June 6, 2011). 5 Recognizing rental revenue on a contractual basis is consistent with how most real estate funds that report on a fair value basis recognize revenue. However, it is inconsistent with IAS 40, under which revenue is recognized on a straight-line basis over the lease term.

Presentation and Disclosure The FASB’s tentative decisions on the investment property standard regarding presentation and disclosure will affect the face of the financial statements of certain real estate companies. The FASB has tentatively decided that investment property entities will be required to separately present both rental income and rental expense in the financial statements. In addition, the fair value of investment properties and any associated debt secured by investment property will also be reported as separate lines in the financial statements.

The fair value disclosures for investment property entities are expected to be the same as those required under the current fair value measurements guidance.

Challenges for Real Estate Companies Overall Lease Decisions Although there are many reasons entities choose to lease rather than own real estate, the elimination of “off balance sheet” financing removes one benefit of leasing. Within the real estate industry, there has been some discussion about whether the new lease It appears likely that standard will cause tenants to consider moving toward shorter-term leases or owning, both the new lessor rather than leasing, real estate. Tenants have indicated that they would address certain other business considerations accounting standard before changing their real estate strategy. Many believe that shorter-term leases would result in higher rents, reduced leasehold improvements or allowances, and uncertainty and the investment regarding renewal rates. Many also believe that owning real estate reduces their flexibility property standard to relocate, requires additional up-front financial investment (as opposed to the 100 percent financing available under a lease), and creates additional will be difficult to responsibilities. apply. As a result, many tenants have indicated that a change in the lease accounting standard will generally not cause them to change their desire to lease real estate. However, some believe that well-capitalized entities that have typically entered into long-term, single- tenant space may revisit their decisions regarding leasing as opposed to owning. Financial Statement Complexity It appears likely that both the new lessor accounting standard and the investment property standard will be difficult to apply. As a result of the financial reporting changes, real estate companies will be required to gather and analyze key data related to their leases, cash flow models, and valuation assumptions for each real estate investment. Technology Issues Because of the level of detail that will be required related to the processing and storage of individual lease and cash flow models, real estate companies with large portfolios of real estate will need to assess their current technology and systems and determine whether they have the capabilities to store large amounts of data, perform the necessary calculations, and provide accounting entries on an ongoing basis in accordance with the new accounting standards. The automation of this process will be imperative for effective and efficient financial reporting.

6 Thinking Ahead We expect that the boards will attempt to complete their redeliberations of the lease project at their fall 2011 joint meetings and that in November they will issue a revised ED with a 120-day comment period. Real estate companies should maintain active participation in this process. A final standard is expected in mid to late 2012. The FASB expects to release an ED on its investment property project before the end of 2011. Companies, including real estate investors, should ensure that they submit comments before the end of the comment period. Because many of the tentative decisions discussed above have been subject to close votes, it is conceivable that, upon receipt of the comments, the boards will reverse or change such decisions as they continue to deliberate the proposals and evaluate constituent feedback. While the details of the proposed rules will be subject to ongoing refinement, there are many things real estate companies can do to begin preparing. Specifically, they can start to identify and evaluate the challenges introduced by the proposed rules, both in terms of adoption demands and broader business impacts. By planning early, real estate companies can more effectively manage what promises to be, for many, a complex and resource- intense implementation.

Other Deloitte Resources • August 17, 2011, Heads Up, “Recap of Lease Redeliberation Results.” • September 8, 2011, Dbriefs webcast, “Leases: A Comprehensive Update on the Joint Project.”

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Dbriefs for Financial Executives We invite you to participate in Dbriefs, Deloitte’s webcast series that delivers practical strategies you need to stay on top of important issues. Gain access to valuable ideas and critical information from webcasts in the "Financial Executives" series on the following topics: • Business strategy & tax. • Financial reporting. • Sustainability. • Corporate governance. • Financial reporting for taxes. • Technology. • Driving enterprise value. • Risk intelligence. • Transactions & business events. Dbriefs also provides a convenient and flexible way to earn CPE credit — right at your desk. Join Dbriefs to receive notifications about future webcasts at www.deloitte.com/us/dbriefs. Registration is available for this upcoming Dbriefs webcast. Use the link below to register: • Leases: A Comprehensive Update on the Joint Project (September 8, 2 p.m. (EDT)).

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