Gray, Gray & Gray, LLP
Changes to the way leases are treated for accounting purposes were issued back in 2016 but are just now becoming effective. The new standard significantly changes how leases are recorded and will have an impact on both tenants and landlords.
The new Financial Accounting Standards Board rules (ASC Topic 842 for the accounting geeks out there) go into effect on January 1, 2019 for public entities and January 1, 2020 for all non-publicly traded entities.
Impact on Tenants
Under the new standard, tenants will need to record a liability associated with each lease. The liability will essentially equal the present value of the lease payments. Briefly, the liability would be equal to the total of unpaid lease payments, calculated at present value using the discount rate. Do the math and you can quickly see that a 10-year real estate lease may require that a very large liability be recorded on the books of tenants. An offsetting asset, called a “right-of-use” (ROU) will also be recorded.
It should be noted that landlords who build on land that they lease from another party are considered tenants, so are also subject to recording a liability on present value of the land lease payments. For a typical 99-year lease this could be a significant amount.
There is an “out” for leases with terms less than 12 months and which do not include an option to purchase the underlying asset. If this short-term election is made the lessee can apply accounting methods that are similar to current operating lease standards.
Impact on Landlords
From a landlord’s perspective, the changes under ASC 842 are not as drastic. Current accounting treatment requires landlords to recognize rental income on a straight-line basis over the term of the lease. If there are escalating rental payments, we record the average amount of lease payments as income each month, and the record the difference between this average amount and what the tenant currently pays as an asset or liability. This treatment will not change under the new standard. What will change are the accounting for non-lease components, specifically the indirect costs associated with obtaining a lease.
Under the new standard, initial indirect costs will now only include costs that would not have been incurred if the lease ultimately is not executed. For example, a commission to the real estate broker would not be incurred if the lease is not ultimately executed. So, under the new standards commissions would continue to be considered an initial indirect cost and amortized over the life of the lease.
However, costs to negotiate or arrange a lease that would be incurred regardless of whether the lease was obtained are no longer considered initial indirect costs under the new standard and these costs will now be expensed when incurred. For example, legal and other professional fees are incurred and paid by the landlord even if the tenant walks away and fails to execute the lease. Rather than capitalize these costs and amortize them over the life of the lease, these costs can now be expensed.
Impact on Lending Covenants
This new accounting treatment only applies to financial statements that are based on Generally Accepted Accounting Principles (GAAP). Many real estate professionals, on the other hand, report on an income tax basis, so would not need to apply these new rules. However, some lenders require GAAP-compliant financial statements, with the debt subject to certain financial covenants calculated on those GAAP financial statements. These calculations could change due to the new standards.
Tenants may want to modify the way leases are structured to minimize the impact on their financial statements. One way is to shorten lease terms, as a longer lease creates a larger right-to-use asset and bigger liability on the balance sheet. We may also see more net leases, as gross leases and fixed payments also boost the right-to-use asset value. Landlords may also wish to begin allocating a larger share of rent to common area maintenance or other shared cost to help lower fixed rates and reduce their tenant’s balance sheet asset.
Because the assets and obligations of a lease are not, in themselves, changing, the new accounting standards will not have an impact on the overall cost of a lease. What will change is how the numbers involved are reported, which is likely to have a big impact on financial statements.