in better and more complete financial reporting information about lease contracts being available to investors and others," said Sir David Tweedie, chairman of the IASB, in a statement. Osnoss' colleague, global IFRS leader Veronica Poole, calls the ED "a long-overdue reality check, which will mean greater accounting transparency for listed companies."

The lease accounting standard proposed by the FASB and IASB would eliminate

the two current classifications: operating or capital leases. Operating leases are recorded as an expense in the income statement over the life of the lease, but generally do not appear on the balance sheet, capital leases are recorded as assets on balance sheets, and then depreciated as an expense item in the income statement. The former gives the lessee only the right to use the property, while with the latter, the lessee assumes some of the risks and benefits of ownership.

A lease is considered a capital lease under the FASB's FAS 13 if it meets one of the following four criteria: it conveys ownership to the lessee at the end of the lease term, the lessee has an option to purchase the asset at a bargain price at the end of the term, the term of the lease is 75% or more of the economic life of the asset, or the present value of the rents, using the lessee's incremental borrowing rate, is 90% or more of the asset's fair market value. FAS 13 has generally required such a "bright line" classification of leases over its 34-year history.

In place of these two treatments would be what the two boards call "a consistent approach" to lease accounting for both lessees and lessors, one that puts all leases on balance sheets. This "right of use" model, according to law firm Seyfarth Shaw, assumes that each lease creates both an asset (the lessee's right to use the leased asset) and a liability (the future rental payment obligations).

Or as Bob O'Brien, Deloittes US head of real estate, puts it, "They will have to put an asset on the books for the right to use space over the lease term, plus any renewal options that are likely to be exercised. Then they're going to have to put an offsetting obligation on the books as well as for the liability associated with the right to use space." O'Brien notes that this represents "a drastic change in terms of the accounting impact of leases."

E&Y says landlords that operate under US GAAP will be required to adopt one of two models for each lease: the "performance obligation approach," whereby the landlord records-along with the investment property-a lease receivable and an equivalent liability representing the lessee's right to use the underlying property, or the "partial derecognition approach," under which the landlord must split its investment property between a lease-receivable asset and the property's residual value. Unless the landlord retains the risks and benefits associated with the leased asset, it will have to identify the part of the investment property that it no longer controls, and "derecognize" it from the balance sheet.

The current lease accounting model under FAS 13 has long come in for criticism. An article by Seyfarth Shaw's retail industry team notes that critics of the current standard maintain that "operating leases, in fact, give rise to an asset and a liability that should be disclosed on a company's balance sheet."

By failing to do so, critics say, the current standard produces "a lack of transparency for users of financial statements that require a complete understanding of a company's leasing activities," and reduces the comparability of financial statements between companies that account for their leases differently. These "off-balance sheet" operating lease obligations, Seyfarth says, translate to "significant fixed and contingent liabilities for companies," which have been estimated in the $1- trillion to $2- trillion range.

The Securities and Exchange Commission has estimated that the changes would prompt public companies to put over $1 trillion in assets and liabilities on their financial statements when submitting their lO-Q and 10- K filings to the SEC. Real estate services firm Cassidy Turley says the proposed modifications will result in changes in the timing and classification of expenses on corporations' income statements, "which will impact key financial metrics such as debt-to-capitalization ratio, EBITDA, interest coverage and other metrics,"

For commercial real estate, the implications of the new standards are considerable. Among them are a possible shift to shorter-term leases as tenants seek to minimize the impact on their balance sheets and income statements. This in turn could increase uncertainty around lease cash flows for owners and therefore "could adversely affect the valuation of real estate for investors due to increased roll-over risk," Roth says. Lessees with access to capital may opt to buy their real estate rather than lease it.

However, O'Brien isn't so sure that either change in tenant behavior will actually come to pass. "We've had some informal conversations with a number of lessees, trying to get a sense of whether they're going to look at things differently," he tells Distressed Assets Investor. Asked whether they'd lean toward short-term leases, "the vast majority of lessees have said no. The economics around short term leases, including what they would expect to be higher costs around those leases and in some respects reduced flexibility, outweigh the accounting." Those that might consider it are lessees "that are already financially challenged."

On the question of leasing space versus buying it, "We are starting to get indications that some will more seriously consider the buy component, particularly triple-net lessees that are using an entire property," O'Brien says. "A big-box retailer would be a great example. Not everybody's going to buy the real estate, but we think some lessees out there will be more likely to."

More than lessee behavioral patterns stand to be affected by the new accounting standards, though. Because lessees will now be recording an interest and amortization expense rather than a rent expense, "any financial performance measurements that are based off net income or earnings measures will be impacted," says Roth. That means, he explains, that EBITDA will improve, but covenants such as interest coverage ratios could be adversely impacted, and consideration will have to be given to other contracts that utilize earnings measures, such as compensation agreements.

Lessees and lessors operating under the performance obligation model will be required to gross up their balance sheets by the present value of the expected lease cash flows over the term of the lease. As a result, Seyfarth says, "debt covenants in finance agreements may be violated or triggered due to material changes in applicable financial ratios." Heavily leveraged retailers, for example, could become technically insolvent or worse.

Given the possible impact on debt covenants, Roth says companies may need to negotiate amendments to lease agreements to consider the new leasing model. "Companies may be hesitant to approach lenders with such a request in this uncertain credit environment," he says.

This new leasing model will require "significant assumptions" on the part of lessees and lessors, Roth says, including the probability of exercising extension options and contingent rentals. They will need to determine what is the longest term that is more likely than not to occur for a given lease. Companies will be required to develop processes and controls for identifying these assumptions, leading to what Cassidy Turley calls "an administrative burden."

"The systems requirements shouldn't be underestimated," warns O'Brien. "The projections you're required to do to anticipate the lease payments you'll be making over the term of the lease, and accounting for those lease payments, are not insignificant, particularly for a retailer that has 800 or 8,000 locations."

Given the ramifications of the new standards, and the likelihood that the FASB and lASB will enact them pretty much as presented in the ED, companies such as E&Y are urging their real estate clients to prepare now. For its part, Seyfarth spells out these preparations, starting with an evaluation of the ED and the new lease accounting rules.

The law firm also recommends clients monitor the comments and review the final standard when it's issued, probably sometime in 2011.

Lessees and lessors alike should also measure the likely reporting effect across their leasing platform and the potential impact on the balance sheet, Seyfarth says. The firm further recommends that clients review the effect of new reporting requirements on existing legal documentation related to their debt obligations and adverse effects on their companies' valuation and credit ratings.

The internal review, technology and process changes required by the new rules need to be budgeted and planned for, Seyfarth says. That will mean educating the appropriate internal groups responsible for assessment, measurement and reporting as well as determining who will make the "difficult" calls about certain decisions such as the most likely lease term and estimates of gross sales for percentage rent purposes. Finally, the lessee should reassess its leasing program and requirements "to minimize the impact of the new standard."

The FASB and lASB are accepting comment letters on the ED through Dec. 15, they will then begin redeliberations upon conclusion of the comment period. The two boards plan to undertake various outreach activities during the comment period. They intend to issue a final standard in 2011, the effective date of the new rules has yet to be determined. On the horizon is another FASB proposal, similar to the lASB's lAS 40, which would require recording investment property at fair value. An ED has not yet been issued for this accounting standard change, but O'Brien and others say the proposal is being watched closely.

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