Eight Things You Need to Know About the New Lease Accounting Rules
By Glenn S. Demby, Esq.
You don’t need us to tell you that big changes in lease accounting rules are afoot. And if you’re looking for technical analysis of the new rules, you’ll find tons of it online. The problem is that without an accounting background, you’ll have a hard time digesting it. And what you won’t find on the Internet is a plain English explanation for non-accountants. So we decided to create one. Here are the eight things that tenants of commercial real estate need to know about the proposed new accounting rules and their impact on leasing.
1. What’s at Stake
Accounting rules require companies to keep two basic financial statements:
- A balance sheet listing assets and liabilities showing what the company owns and owes, with recorded assets equaling, or “balancing,” recorded liabilities plus equity; and
- An income statement (a.k.a. P&L) listing the company’s revenues and expenses, which makes it possible to calculate the company’s profits and losses.
These financial statements aren’t just a technical exercise in bean counting. They directly affect a company’s ability to attract investors and get bank loans, and even affect how much it pays in taxes.
2. How Current Lease Accounting Rules Work
A lease is one of the transactions that a company must account for on its financial statements. How the company does that depends on the kind of lease. There are two possibilities:
Operating leases are transactions in which the owner (a.k.a. “lessor”) gives the tenant (a.k.a. “lessee”) a right to use land or another asset. The tenant doesn’t own the asset and must return it to the owner after the lease ends. Most standard commercial real estate leases are operating leases.
Capital leases are essentially purchases in which the tenant acquires an ownership interest in the leased asset. Examples include leases that transfer ownership of the property to the tenant at term’s end, give the tenant an option to purchase the property at less than its fair value and/or last for as long as the asset’s remaining economic life.
Accounting-wise, the most important difference between the two kinds of leases is that tenants aren’t required to record operating leases on their balance sheet. The chart below summarizes the rules:
Operating Lease Accounting Rules
- Not required to list lease on balance sheet
- Report rent paid as rent expense on “straight-line” basis over life of lease as an average rent of equal amounts for each year of lease term (1)
- Report rent amount as:
>Rental property asset; and
>Debit to lease receivables (or cash) account
- Keep asset on balance sheet and depreciate (reduce in value by amount consumed) on a straight-line basis over lease term
- Report rent due as rent income on “straight-line” basis over life of lease as an average rent of equal amounts for each year of lease term (1)
- Report depreciation expense on leased asset
(1) Rent income/expense is shown as a straight line even though most leases provide for higher rent over each year of the lease.
Capital leases are treated like purchases in which the tenant acquires an ownership interest that’s recognized on the balance sheet and P&L. Summary:
Capital Lease Accounting Rules
- Report asset = full market value of right to use space; and
- Report liability = net present value of rental stream over life of lease
- With each payment:
>Debit lease payables
- Report imputed interest on unamortized balance as downward-sloping line over life of lease—in effect, lease treated as a mortgage in which you report not just a reduction in the capital lease liability but imputed interest on unamortized balance with more interest paid in early years of lease;
- Report amortization expense on leased asset
- At start of lease, owner reports present value of all rents due under lease as:
>Credit to owned assets;
>Debit to lease receivables
- With each payment, owner:
>Credits lease receivables;
>Credits interest income
- Report rent due as rental income on straight-line basis over life of lease
3. Why the Rules Are Changing
The new accounting rules propose to change how leases must be recorded on the balance sheet and P&L. The biggest change: elimination of the rule that tenants don’t have to list operating leases on their balance sheet. From now on, all leases will have to be shown on the balance sheet.
Explanation: The point of accounting rules and financial statements is ensuring that investors, banks, regulators, and other stakeholders in the financial system get the information they need to make sound judgments about a company’s financial condition. The boards that make the accounting standards [like the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB)] felt that letting tenants keep operating leases off their balance sheets was creating too big a blind spot in the system. According to one government report, off-balance sheet leasing commitments total approximately $1.25 trillion—and that’s only among publicly registered companies.
4. When the New Rules Will Take Effect
FASB and IASB are still working on the rules (which are contained in a 343-page document called the “Revised Exposure Draft,” published on May 16, 2013). And experts say the rules probably won’t take effect until Jan. 1, 2017, at the earliest.
That sounds like a long time. But like objects in the passenger-side rearview mirror, 2017 is closer than it appears. For one thing, there’ll be no “grandfathering” of existing leases. All leases will have to be accounted for in accordance with the new rules on the effective date no matter when they were signed or took effect.Result: Owners and tenants will have to revise their balance sheet and P&L before the rules actually take effect so they comply on day one of the new regime. And if your company is required to provide a three-year comparison in its financial statements, once the final rules come out, you’ll have to revise your 2015 and 2016 financial statements.
5. The Four Things You’ll Have to Do to Comply
Under the proposed rules, companies will have to record all leases longer than 12 months on their balance sheet and follow new rules for calculating and recording leases on their financial statements. Compliance will be a four-step process:
Step 1: Determine if your lease is covered. Remember that the rules apply only to leases that last 12 months or more. Most commercial real estate leases will satisfy the 12-month rule, explains Indianapolis CPA Ron Smith, including leases of less than 12 months:
- That give the tenant an option to renew the lease or purchase the property; and
- Where the tenant is “reasonably certain” to exercise the option in light of all the economic factors.
Step 2: Classify the lease as Type A or B. Once you determine that the lease is covered, you must figure out what type of lease it is. “Operating” and “capital leases” are going away. Under the new rules, leases will be classified as either:
Type A leases, which are effectively a sale or financing; or
Type B leases, which are essentially the same as operating leases under the current rules.
Smith’s recommendation: In making the classification, tenants should ask this question: Is the lease effectively an installment purchase of the property? If so, the lease is a Type A; if not, the lease is a Type B.
Rule of thumb: Office building, retail, and other standard commercial real estate leases classified as operating leases under current rules are likely to be Type B leases under the new rules; leases currently classified as capital leases are likely to be Type A leases.
Step 3: Properly account for the lease on your balance sheet. You must record Type A and B leases on the balance sheet—both at inception and on a subsequent basis in response to significant economic changes:
First Phase: Initial Recognition. To recognize a Type A or B lease when the lease begins, list:
1. A new asset representing the value of your right to use the property (ROU asset). Formula: The ROU asset’s value is the present value (that is, a dollar value that’s discounted to reflect the fact that a dollar in the future is worth less than a dollar right now) of future lease payments over the lease term. Include your initial direct costs in relation to the ROU asset, Smith advises. Also make sure you know what future lease payments do and don’t count:
Calculating Future Lease Payments
Payments that Do Count
Payments that Don’t Count
- Fixed rent
- Variable payments linked to an index or rate
- Amounts to be paid under residual value guarantees (1)
- Termination penalties
- Initial direct costs
- Variable payments based on sales, performance, or usage of the asset
- Option payments—unless there’s a significant economic incentive to exercise the option
(1) Residual value guarantees are amounts the tenant promises to pay the owner at the end of the lease to protect the owner against excessive depreciation of the property over the lease term.
Once you total up future lease payments, discount them to get their present value. The discount rate is the rate your owner charges its tenants. If you can’t determine that rate, use your incremental borrowing rate—that is, the interest rate you’d have to pay to borrow an asset of similar value to the ROU asset. If your company is a nonpublic entity, you can make an election to use the risk-free rate as your discount rate, Smith adds.
2. A lease liability. Formula: Remember that under accounting rules, the value of the liability must be the same as the corresponding asset.
You must present your Type A and Type B lease ROU assets and liabilities as separate line items on your balance sheet or in the notes to your balance sheet.
Second Phase: Reassessment. Over the course of the lease, you’ll have to reassess the value of lease payments you reported as well as the discount rate you used to calculate their present value to reflect lease modifications and other important changes affecting:
- The term of the lease caused by a significant event or change in circumstances that are within your control;
- Variable lease payments based on an index or rate to the extent you decide to re-measure the ROU liability for other reasons; and/or
- The discount rate you used to calculate the ROU asset in response to changes in the lease term or your option to purchase the property.
Step 4: Properly account for lease expenses on your P&L. As under current rules, you’ll have to account for all lease-related expenses on your P&L. You must recognize two lease-related expenses on the P&L:
- Amortization of the ROU asset—that is, the amount by which the asset’s value is reduced as it’s consumed over the lease term. The ROU asset is amortized on a straight-line basis over the term of the lease. For example, an ROU asset recorded at $1 million for a 10-year lease is amortized at $100,000 per year; and
- Interest expense related to the lease liability.
While the lease-related expenses are the same for both types of leases, there are important differences in the method you use to recognize them on the P&L:
Type B lease: Combine the amortization and interest on a Type B lease into a single lease expense that you recognize on a straight-line basis over the course of the lease.
Type A lease: Treat amortization and interest on a Type A lease as separate costs. That’s a big deal because while amortization costs are straight-line, interest expenses are higher in the early years of the lease and decrease over time. The result of this “front-loading” is that you’ll have to recognize significant interest costs on your P&L when you enter into a Type A lease. Those added P&L expenses could affect your paper profitability and harm your standing with investors and creditors.
Click here for a visual comparison of the impact of the different expense recognition rules for Type A and B leases over a 10-year lease term.
6. How the New Rules Will Affect You
The P&L accounting rules for Type A lease expenses are like the current rules for capital leases (although Type A leases are defined more broadly than capital leases under current rules and may sweep in some leases that are today classified as operating leases). But the real impact of the new rules is that you will no longer be able to keep leases off your balance sheet by structuring them as operating leases.
The scary part of the new rules isn’t just that you have to list leases on the balance sheet, it’s how you have to do that. You must record your total lease payment obligations over the course of the lease as an up-front liability at the start of the lease. And that’s not chump change: Total payments due under a commercial lease can run into six, seven, and eight figures.
Adding a massive new liability to the balance sheet each time you enter into a lease may do at least some harm to your company’s financial position. The more leases you make, the more your financial statements and ratios will suffer, and the harder it will be to lure new investment and loans. The added liabilities may even cause you to default on your current loans. Consider the following example:
Example of Proposed New Rules’ Impact on Existing Bank Loans
Tenant leases 15,000 square feet of retail space for seven years for $32 per square foot on a triple net basis for total rent of $3.36 million.
Tenant’s bank loan agreement requires tenant to have a debt-to-equity ratio of below 1.0:1.0. Before entering the lease, tenant has total debt of $5 million and total equity of $7 million, for a ratio of 0.71:1.
Current Rules: Tenant doesn’t have to list the lease on its balance sheet, so its ratio remains at 0.71:1.
Proposed New Rules: Tenant must record the new lease on its balance sheet at the start of the lease by listing an asset (right to occupy the space) of $3.36 million and a corresponding liability (total rent due) of $3.36 million, and reduce them both over the lease term. (For simplicity, the total lease payments will be used and not the net present value of the total lease payments.)
Result: At lease start, assets and liabilities increase by $3.36 million. So the tenant’s liabilities are now $8.36 million. (There’s no change to equity). This changes the tenant’s ratio to 1.19:1. By going above 1.0:1.0, the tenant is in default under the loan.
7. Why Shorter Term Leases May Not Be the Best Answer
It’s imperative that you factor the new balance sheet reporting requirements into your lease negotiations. You need to consider whether the lease you’re negotiating is a Type A or Type B and how the lease’s economic terms will be reflected as assets, liabilities, revenues, and costs on your financial statements. One possibility is to negotiate for shorter lease terms and renewal options. After all, the shorter the lease term, the smaller the ROU asset and future lease payment liability you’ll have to initially recognize on your balance sheet at the start of the lease.
Caveat: The short-term lease strategy won’t work for all tenants. You shouldn’t use it if significant construction is planned for the space since any reductions in the ROU asset are likely to be wiped out by higher amortization costs over the initial lease term. Explanation: Regardless of who pays them, construction costs must be amortized over the lease. The shorter the lease, the higher the amortization rate (for example, $10,000 is amortized at $2,000 per year in a five-year lease and $5,000 per year in a two-year lease).
Getting a renewal option to extend the amortization period won’t solve the problem. That’s because extending the amortization period gives you “a significant economic incentive” (see the chart on counting future lease expenses above) to exercise the option. Result: You have to count future lease payments during the renewal period in calculating the ROU asset. In essence, the renewal option plus incentive to exercise turns the lease into a longer term lease, effectively undoing the short-term lease strategy.
And, of course, there’s more to leasing than accounting. Thus, if you’re in retail or another business where staying in one location is crucial, minimizing the ROU asset may be less significant than the stability of a long-term lease.
8. Four Leasing Strategies You Can Use to Protect Your Company
Leasing strategies for tenants that do make sense in a balance-sheet reporting world include:
Strategy 1: Shift costs to non-reportable expenses. Remember that the value of the ROU asset recognized on the balance sheet is the present value of future lease payments, including fixed rent, variable lease payments pegged to an index or rate, and residual value guarantee payments. Result: You can reduce the value of the ROU asset by shifting payment obligations to payments that don’t count, like variable payments based on sales, performance, or usage of the asset such as CAM, and other operational expenses.
Strategy 2: Make leases triple net. One of the best ways to shift future lease payments to non-reportable operating costs is via a triple net lease in which you agree to pay fixed rent and a pro rata share of CAM, insurance, and taxes. You also want to make sure that operating cost payments are based on actual costs rather than adjustments against a base year since lease payments become reportable when they’re tied to an index or rate.
Strategy 3: Make owner commit to financial transparency. Remember that new rules require you—and the owner—not only to recognize the initial value of the ROU asset but reassess it to reflect significant economic changes. So require the owner to:
- Monitor the relevant variables, such as the index or rate to which a particular lease payment is pegged;
- Notify you of changes; and
- Provide the data you need to make your own reassessments.
Strategy 4: Structure leases as Type B, not Type A. Although both types of leases must be recognized on the balance sheet in the form of the bloated ROU asset, the P&L recognition rules for Type Bs are kinder and gentler because they let you combine amortization and interest expense as a single lease cost on a straight-line basis. So structuring leases as Type Bs enables you to avoid the dreaded front-loaded, downhill interest expense slope that must be shown on the Type A P&L.
Glenn S. Demby is a corporate attorney and award-winning legal journalist who specializes in explaining the law in plain English and helping business leaders overcome their regulatory challenges. He can be contacted at firstname.lastname@example.org.
Ron Smith, CPA: Partner, Katz, Sapper & Miller, 800 East 96 St., Ste. 500, Indianapolis, IN 46240,email@example.com.