How the New Lease Accounting Rules Affect Landlords and TenantsBy Mark Cuccia | August 19, 2019
By Mark Cuccia and Adeline Lee
In February 2016, the Financial Accounting Standards Board (FASB), which determines financial accounting and reporting standards for public and private companies as well as not-for-profit organizations, issued a new lease accounting standard. This new standard, which affects any entity that has entered into a lease, has already become effective for all public companies. At the time of this publication, FASB has tentatively deferred the effective date for private companies, offering them welcome relief by shifting the new effective date to January 1, 2021. Private companies in the real estate sector can consider this deferral a major plus, as the new standard significantly changes how leases are recorded and is anticipated to have a profound impact on the books of both real estate lessors and their tenants.
Under the old lease accounting standard, there were two types of leases - capital and operating. A capital lease transferred the control of the asset to the lessee at the end of the lease, while an operating lease did not. Once a lease was classified as a capital lease, the lease asset and related liability were to be recorded on the balance sheet.
Under the new standard, a lease is now categorized as either a finance or an operating lease. A finance lease is very similar to a capital lease - it transfers the control of the asset to the lessee at the end of the lease, while an operating lease does not. The main difference between the old and new standards is that now, both finance and (in most cases) operating leases recognize lease assets as a right-of-use (ROU) asset and future lease payments as the lease liability on the balance sheet. The amount of the lease liability and the value of the ROU asset is calculated based on the present value of all future lease payments. The longer the lease, the greater the liability.
This new standard applies to all leases, including subleases, with a few exceptions such as leases of inventory, intangible assets and assets under construction. It does not apply to leases with a lease period less than 12 months and with no option to purchase the asset. It does not require existing and expiring leases to be reassessed, nor does it apply to income tax basis financial statements.
The new lease accounting standard significantly affects both real estate lessors and tenants, albeit in different ways. Some of these are discussed below.
• Real estate lessor-lessee
Real estate lessors are in fact lessees if they have leases of land, office space, office equipment and other leased assets. When a lease meets certain criteria, the ROU asset and related lease liability are to be recorded on the books. This will not only affect the financial statement presentation but also skew the financial metrics. The impact will be even more significant when there are ground leases. Lessors with ground leases should start a conversation with their ground lease lessors and lenders soon.
• Lease components
The new standard requires real estate lessors to evaluate various lease components within contracts and assign a value to each component unless they meet certain criteria. For a real estate lessor who leases an entire building and is inherently leasing the land underneath the building, the new standard requires the land component to be assessed and a value to be assigned separately from the building component, unless the accounting effect is not deemed significant. The rationale behind this is that the land component has an indefinite economic life whereas the building component does not.
• Non-lease components
Many real estate lease agreements include services provided by the lessors, such as common area maintenance and janitorial services. These services are considered non-lease components. Under the new lease accounting standard, real estate lessors are required to assign a value to both lease and non-lease components based on a standalone price. Real estate lessors can elect to apply a practical expedient to not separating the non-lease components from the lease components, provided both components share the same timing and pattern of transfer, and the lease
component would be classified as an operating lease. Real estate lessors that plan to elect the practical expedient should start the evaluation process early in order to determine if they qualify for the election. Once elected, the practical expedient must be applied consistently, by asset class, to all lease transactions of a similar nature. Meanwhile, real estate lessors can expect closer scrutiny of embedded service components by lessees in upcoming lease negotiations.
• Initial direct costs
Under the new lease standard, initial direct costs are redefined as costs that would not have been incurred if the lease had not been obtained, such as leasing commissions. Costs that meet this definition will continue to be capitalizable and amortizable over the term of the lease. Expenses that are no longer considered initial direct costs under the new standard will be expensed when incurred, such as legal fees related to the leasing. This change will affect certain key financial metrics, such as funds from operations and Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA) calculation. Real estate lessors may be impacted by this new standard if tenants begin looking for ways to restructure their leases in order to mitigate the impact on their financial statements.
• Lease term
Under the new lease accounting standard, shorter lease terms become more attractive, as they lower the lease liability. Shorter lease terms will help tenants who are particularly concerned with meeting their debt service coverage ratio. This, however, may not align with the lessors’ objectives, as shorter lease terms increase resource outlay in the long run and risk an unknown future. In addition, shorter lease terms could greatly affect lessors’ real estate valuations and their ability to obtain long-term financing.
• Lease payments
To mitigate the impact on their financial statements, tenants may wish to negotiate the nature of their lease payments. Under the new standard, variable payments that are not based on index or rate are not includable in the ROU asset and lease liability calculations, as they are not fixed and determinable. As a result, retail tenants might negotiate a lower fixed rent with a higher variable rent component based on percentage rent. Tenants may prefer a net lease to a gross lease when looking to reduce liability. When determining lease payments, payments in connection with options to purchase the lease asset, to renew the lease, or to terminate the lease can be included when it is reasonably expected that the option will be exercised by tenants.
• Lease classification
Tenants who are concerned with EBITDA might want to structure their current operating leases with a longer lease term and options to renew in order to meet the finance lease criteria. Lease payments under a finance lease are categorized as interest and amortization expenses of the ROU assets, which will give the EBITDA calculation a boost. However, while restructuring a lease into a finance lease might be beneficial to lessees, it may not be in line with the lessors’ wishes.
The new lease accounting standard dramatically affects real estate lessors and lessees, albeit in different ways. Even though the economics of a lease do not change, the reporting requirements do, and these new requirements will have a significant impact on the financial statements of both real estate lessors and their tenants. At the same time as tenants are preparing to adjust to the new standards, real estate lessors can expect to spend additional time and effort preparing for the changes to take effect—at the very least on tenant lease negotiations.
About Mark Cuccia
Mark R. Cuccia, CPA, is a Partner in the Commercial Business Group at Marks Paneth LLP. With over 20 years of experience, Mark is dedicated to serving clients across a wide range of industries including manufacturing, importing, wholesale and distribution, retail, restaurants and professional services. He is responsible for overseeing all aspects of his clients' audit, review and compilation engagements and frequently assists with forecast and projection modeling. Mark has conducted numerous in-house accounting and... READ MORE +