By Mark Leverette of BPM LLP[dropcap]T[/dropcap]he recent updated rules for business leases, as prescribed by the Financial Accounting Standards Board, or FASB, will affect developers, landlords and real estate investment funds. Those lessee companies that are heavier in leased assets, or off-balancesheet lease liabilities, will certainly be affected in a big way. However, let’s not overlook the significant effects to lessors too, including revenue recognition, strategy in negotiating with tenants, and cost capitalization. The FASB’s new lease accounting standard, ASU 2016-02, Leases (ASC 842), affects virtually all businesses, and is significant to many. Lessees financial statements will experience changes to the balance sheets, and in many cases, to reported earnings. Lessor accounting is updated as well, and will mirror certain changes in the lessee model, including alignment to the new revenue recognition standard also coming effective. Make note that any equipment leased also applies under both the lessee and lessor’s accounting considerations.
There is No Place to Hide
Lessees will be required to reflect virtually all of their leases on the Company’s balance sheet. From a lessee’s perspective, the FASB retained a dual model including “financing leases” accounted for similar to today’s capital leases and “operating leases” with expense recognized on a straight-line basis. Determining whether a lease is a “finance” or “operating” lease will continue to be a calculation similar to former capital lease rules, but there will be more flexibility to weight the various terms of the lease. At the end of the day, the goal is to get away from bright-line rules based accounting, but portray the economic effects of the lease contracts.
Similar to the model in the new revenue standard, the approach is based on control of the asset, and means a sale can only occur when control of the asset has transferred. If no transfer occurs, an arrangement otherwise qualifying as a finance lease would be accounted for as a direct financing lease (i.e., the underlying asset would be derecognized, but upfront profit would not be recognized).
Major Lessor Changes
1. Operating leases get additional flexibility – The new guidance allows for the lessor to determine if there is a more systematic or rational allocation of lease income than a straight-line. Although there would be limited circumstances, this bpmcpa.com © 2017 BPM is consistent with the move toward the reflection of contract economics, rather than following the strict bright-line rules of the former GAAP.
2. Sales-type leases – Can get more complicated if there any questions about collectability over the lease term, or if an asset does not actually transfer, a sale will not be recognized and all lease payments will be deferred as a deposit until the uncertainty is resolved. Some additional diligence will be required on contractual terms and counterparty credit.
3. Direct financing leases – Treated similarly to sales-type lease, except the lessor recognizes interest income over the lease term in an amount that produces a constant return on the remaining balance of the “net investment in the lease.”
4. Flexibility in the treatment of non-lease revenues – Non-lease components of tenant payments clauses are frequent in lease agreements, and will affect when revenue is to be recognized under the new guidance. Transactions with variable payments could be subjected to the revenue or leasing guidance. A lessor must analyze the contract language and economics to assess which pronouncements are applicable (examples: adjustments of CAM, percentage sales, indexed rates, flexible over-flow space, or space given back space over time).
5. Initial direct costs – The new standard only allows for costs that wouldn’t have been incurred if a lease hadn’t been obtained qualify as “initial direct costs.” This is a significant change to the previous practice for many real estate lessors since they will no longer be able to include allocated costs (e.g., salaries) and costs that are incurred regardless of whether the lease is obtained (e.g., certain legal advice) in initial direct costs.
Watch Out for Financial Covenants
Companies with leases of facilities or equipment under existing operating leases will have more assets and liabilities on their balance sheets. While leases allow many companies to use available capital for other purposes and reduce the overall exposure to the risks of ownership, these lease agreements will also require balance sheet presentation. This will affect financial ratios, changing the way investors and bankers see the overall financial position of the Company, and will substantially impact decisionmaking.
Talk to your bankers before adopting the guidance, and take the time to understand the implications to your financial statements.
BPM’s guide on the “New Lease Accenting” is your resource for understanding the major changes resulting from the new leasing guidance. There, you will find helpful insights on the new lease accounting rules including the overall requirements in accounting and reporting on business leases. The guide will help your company understand the important parts of the transition. BPM is ready to assist with technology and support in the process.
Get Ahead of the Curve
For most companies (i.e. nonpublic companies) this will be effective for their 2020 fiscal year, but the new rules can be adopted early. The FASB’s standard is effective for public companies, certain not-for-profits, and benefit plans for interim and annual reporting periods beginning after December 15, 2018, while private companies have an additional year. Entities are required to adopt the standard using a modified retrospective transition approach, which requires application of the new guidance at the beginning of the earliest comparative period presented in the year of adoption.
Since the effects will likely be significant, you will need to explain the changes in the footnotes of your financial statements, and it may lead to further discussions with important investors, bankers, and your tenants.
- Are you ready when current tenants call? Tenants may seek to alter their leasing strategies as a result of the new guidance, and you will want to understand their key goals and strategies.
- Do you need assistance? Companies may find themselves lacking bandwidth to get the statements in compliance with the new guidance. These additional costs in implementing the guidance can be managed through early employee training, system evaluations, and updating processes and internal controls that align with the new rules. Consult internally with the management team and externally with professional advisers.
- Have you consider current lease contracts? Create an inventory of existing leases and other contracts to roughly evaluate the impact of the change. By understanding the magnitude of these rules, you may find it important to negotiating new financing. The specifics of the changes will likely require some financial modeling, weighing of the possible outcomes, and some technical research.
- Do you want to get started? Many companies are procrastinating, but make sure to talk to your lenders and investors early. Financial statement users may already expect pro-forma information, and you want to stay ahead of your competition.