Aimed at better enabling users of financial statements to have a complete and understandable picture of an entity’s leasing activities, the FASB’s new lease accounting standard, ASU 2016-02, Leases (ASC 842), affects virtually all businesses, and is significant to many. Central to this objective is the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases under previous GAAP. Lessees financial statements will experience significant changes to the balance sheet, and in many cases, to reported earnings. While the changes are primarily targeted at lessee accounting, the lessor model was updated to align with certain changes made to the lessee model and the FASB’s new revenue recognition standard.
Cost Capitalization—Initial Direct Costs
Under current guidance, lessors often capitalize the initial direct costs to obtain a lease. These may have included internal costs, such as evaluating the potential lessee’s financial condition, or external costs, such as paying commissions to brokers or early termination payments to existing tenants. The new standard only allows for costs that wouldn’t have been incurred if a lease hadn’t been obtained to qualify as “initial direct costs.” Costs, such as payroll or general deal diligence, which are not incremental, will need to be expensed as incurred by lessors. This is a significant change to the previous practice for many real estate lessors since they will no longer be able to include these 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.
Sale Leaseback Transactions
Lessors will need to apply the new sale and leaseback guidance, including evaluating whether a sale has occurred under the FASB’s new revenue guidance. For the seller to reflect a sale, and for the buyer to reflect a purchase, a transaction must transfer control of the asset in accordance with the new revenue recognition standard. Entities will need to apply judgement when determining whether control has transferred. If the seller-lessee has a repurchase option and it’s not the asset’s fair value at the time it would be exercised, the transaction would not qualify as a sale. A transaction would also typically not qualify as a sale if the repurchase option is for a unique asset. As real estate assets are generally considered unique, a repurchase option on real estate would generally prevent sale and leaseback accounting. If the criteria for transfer of control are met, the buyer-lessor would recognize the purchased asset on its books. If not, a failed sale and leaseback transaction is considered a financing, and will be accounted for as a loan by the buyer-lessor.
Strategy for negotiating with tenants: In some cases, the provisions that prevent sale treatment may be subject to negotiation. For example, changes to contract terms can impact the control conclusion and repurchase options can be modified or removed.
Transactions with Variable Payments
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 either the revenue or leasing guidance, and may be accounted for differently depending on whether the transaction is subject to the revenue or leasing guidance. Currently, under either standard, lessors recognize variable payments as revenue in the period earned. Under the new standards, if the transaction falls under the lease guidance, variable payments based on usage are not included in the lease receivable or lease income until earned. If the transaction falls under the revenue guidance, variable payments may be recognized as revenue upfront, provided certain conditions are met. A lessor must analyze the contract language to assess which pronouncements are applicable.
Strategy for negotiating with tenants: Lessors and lessees in sales-type leases may have different preferences as to whether rent payments are fixed or variable. Lessees may prefer variable payments based on usage, which are likely to reduce the lease liabilities on their balance sheets, while lessors may prefer fixed payments, which are recognized at lease commencement.
Mark Leverette is a partner and the real estate industry group co-leader at BPM. Contact Mark at [email protected] or call 415-288-6206.
Kristin Harrison is a supervisor in the assurance group at BPM. Contact Kristin at [email protected] or call 415-288-6255.