The 10 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 10 things that owners 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 that 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 the Current Lease Accounting Rules Work

A lease is one of the transactions that a company must account for on its financial statements. There are two types of leases:

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.

3. How to Account for Each Kind of Lease under Current Rules

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. Here’s a summary of the current accounting rules for operating leases:

Operating Lease Accounting Rules

Notes:

Capital leases are treated like purchases in which the tenant acquires an ownership interest that’s recognized on the balance sheet and P&L:

Capital Lease Accounting Rules

4. 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 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.

5. How to Comply with the Rules

Compliance will be a three-step process:

Step 1: Determine if the 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 thing as operating leases under the current rules.

Smith’s recommendation: In making the classification, owners 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. As under current rules, you must record all your leases on the balance sheet. But the rules differ depending on the type of lease involved.

            Option 1: If the lease is a Type B. The new balance sheet and P&L rules for Type B leases are much the same as the current rules for operating leases:

• List the leased property as an asset on the balance sheet;
• Debit a corresponding lease receivable or cash account; and
• Keep the asset on the balance sheet and depreciate it over the term of the lease.

To record Type B lease revenues and expenses on the P&L:

• Don’t record a lease receivable or loss/gain at the start of the lease;
• Recognize rental income on a straight-line basis over the course of the lease;
• Expense initial direct costs on a straight-line basis over the course of the lease on the same basis as rental income;
• Treat the difference between straight-line rental revenues and rents currently billed as unbilled rents receivable; and
• Disclose a maturity analysis of the undiscounted future lease payments to be received for the Type B lease for each of the first five years of the lease and the total amount of lease payments for the remaining years in the notes to the financial statements.

Option 2: If the lease is a Type A. The rules for Type A leases are more complicated. At the start of the lease:

• Recognize the present value of all payments due under the lease (that is, a discount applied to reflect the fact that money paid in the future is worth less than a dollar in hand today) as:

> A debit to lease receivables; and

> A credit to owned assets;

• Include initial direct costs when calculating lease receivables;
• Recognize profit, if any, on the portion of the property that’s considered to be sold to the tenant on the P&L if the lease transfers control of the property to the tenant (don’t recognize selling profit and revenue at lease commencement if the Type A lease does not transfer control to the tenant); and
• If you do recognize selling profit at the start of the lease, also expense direct costs at lease commencement.

Once the lease takes effect and over the course of its term:

• Recognize rent due and interest on a straight-line basis on the P&L; and
• Present an annual maturity analysis of the undiscounted cash flows comprising the lease receivables for each of the first five years of the lease and the total amount for the remaining years of the lease in the notes to the financial statements that reconciles to the lease receivables; and
• Explain any significant changes in any of the components of the net investment in the Type A lease other than the lease receivable that took place since your previous financials. 

6. When the New Rules Will Take Effect

FASB and IASB are still working on the proposed rules (which are contained in a 343-page document called the “Revised Exposure Draft,” published on May 16, 2013). Experts say the rules are subject to change and unlikely to 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 go back and revise their balance sheet and P&L before the rules actually take effect so they’re in compliance on day one of the new regime. In addition, companies currently required to provide a three-year comparison in their financial statements will have to go back and revise their balance sheets and P&Ls for 2015 and 2016.  

7. How the New Rules Will Affect You

The new lease accounting rules shouldn’t prove too disruptive or difficult for owners. The new Type A and B classifications are parallel, although not exactly the same as current operating and capital lease classifications. The new accounting rules for Type A leases will take some getting used to. But most of your leases will probably be Type Bs, which require essentially the same accounting treatment as today’s operating leases.

8. How the New Rules Will Affect Your Tenants

The real significance of the new rules is their impact on your tenants. From now on, tenants won’t be able to keep their leases off the balance sheet by structuring them as operating leases. It’s not simply that tenants will have to list leases on their balance sheet. The new rules also require tenants to record their future 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 under a commercial lease can run into six, seven, and eight figures.

Adding this whopping new liability to the balance sheet may harm the company’s financial position and jeopardize its ability to attract capital and bank loans—especially if the company enters into lots of commercial leases. It could even cause a company to default on its current loans. Consider the following example:    

9. How the New Rules May Affect Your Leases

All of this is the tenants’ problem, not yours. Right? Wrong. The new rules will cause tenants to make new lease demands during negotiations. Some of the lease terms you can expect tenants to ask for:

Shorter, renewable leases:  The longer the lease term, the greater the up-front future lease payment liability tenants must record on the balance sheet. So expect tenants to ask for shorter lease terms and renewal options.

Triple net leases: Of course, tenants will want to keep rent as low as possible to minimize the liability they must record on the balance sheet. Under the new rules, the liability that must be recorded is the present value of future lease payments, including:  

• Fixed rent during the non-cancellable period of the lease; and
• Variable lease payments that are linked to an index or rate.

The calculation does not include:

• Variable payments linked to sales, performance, or operation of the asset, such as CAM; or
• Optional payments unless there’s a significant economic incentive to exercise the option.

Result: Tenants will want to separate the non-reportable future variable payments and options from the fixed and variable payments that are reportable to reduce the total rent due liability. The most obvious way to do this is via a triple net lease in which the tenant agrees to pay fixed rent and a pro rata share of CAM, insurance, and taxes. And to the extent that lease payments become reportable when they’re tied to an index or rate, tenants may also want to base operating cost payments on actual charges rather than adjustments from a base year.  

Accounting & reassessment: Another important aspect of the new rules is the requirement that owners and tenants reassess a lease under certain circumstances, including lease modification. This will require the reassessment of the value of lease payments, including the net present value rate used to discount them up-front, and renewal/purchase options. Such adjustments must reflect significant changes that take place since the previous report, such as changes to the term of the lease. So you should expect and be prepared to accommodate tenant requests for a clear and ongoing accounting of lease payments and other information tenants may need to monitor changes that may require reassessments.

10. How You Should Respond to the New Tenant Demands

Nobody is saying that you have to accept any of these tenant demands. Each owner will have to decide for itself what kind of lease arrangements it’s willing to make. But one thing is certain: To attract and retain tenants in the new world of leasing that the new accounting rules will create, owners must at least understand the financial pressures driving tenants to make these demands. Better yet, they need to be prepared to work with the tenant to fashion a lease that the tenant can feel comfortable recording on its financial statements.

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 glennsdemby@gmail.com.

Insider Source

Ron Smith, CPA: Partner, Katz, Sapper & Miller, 800 East 96 St., Ste. 500, Indianapolis, IN 46240; rsmith@ksmcpa.com.