12 BPM Real Estate Insights
The Savvy Landlord : Updates to Lease Accounting
By Mark Leverette and Kristin Harrison
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
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