In February 2016, the Financial Accounting Standards Board (FASB) issued its long anticipated update to lease accounting, ASC 842 – Accounting for Leases. The changes to the guidance are sweeping, but their impact by industry varies. In many ways landlords’ accounting remains unchanged, but businesses that depend on leased space face a host of new complexities. Retailers, manufacturers, and others will focus on this new guidance in their upcoming lease negotiations.
The new standards classify leases into finance and operating leases. Finance leases cover arrangements that transfer control of assets at the end of their term, include purchase options, cover most of an asset’s useful life, or involve highly specialized assets. The majority of commercial leasing transactions are expected to be classified as operating leases, since transfer of control is atypical, and spaces with custom buildouts can eventually be “white boxed” for new tenants.
Under the existing guidance, lessees recognize the expense of an operating lease ratably over its life. This “straight line” approach results in a more consistent bottom line. Moving forward, in addition to reporting a straight line lease expense in their financial results, lessees will need to recognize an asset and a corresponding liability on their balance sheet. One of the most significant sources of lessees’ off-balance sheet financing and risk is now front and center in their financial statements.
Lease Classification and Impact
Both finance and operating leases are initially accounted for as “right of use” assets, with a corresponding liability. The amount of the liability and the value of the asset are based on the present value of all future lease payments.
For tenants concerned with meeting debt covenants, a significant increase in liabilities may present challenges with lenders. Seeking out shorter lease terms will likely benefit these types of prospective tenants. This increases the likelihood that landlords and tenants will not be aligned with respect to lease terms.
Lease classification will also impact tenants’ debt service coverage ratios, which are usually based on EBIDA. A finance lease has two expense components, interest and amortization expense, which are excluded in EDIDA calculations. The expense of an operating lease is recognized on a straight line basis, usually as rent or lease expense, which will factor into the EBIDA measure.
In this respect, finance leases become a more attractive option for tenants, and they may be more aggressive in seeking out lengthier leases, build-to-suit arrangements, and bargain purchase options.
The nature of lease payments will also impact tenants’ balance sheets. Variable lease payments are not included in the measurement of a lease liability and corresponding asset, since this liability is not fixed. Common examples of variable lease payments include rental increases based on CPI, or percentage of retail sales. In both of these examples the tenant’s initial base rent may be the only payment which, in substance, is fixed. The CPI or retail sales can increase or decrease over time, and are therefore not estimable. Cash flow projections based on fixed lease payments will be more accurate and useful to any tenant’s financial planning. However, the liability associated with a fixed payment lease will generally exceed the liability of a lease based on variable payments. Tenants may seek to negotiate greater variable terms in their lease payment structure to take advantage of this accounting treatment.
Commercial leases often include multiple, separate, lease components. Consider a net leased refrigerated warehouse with specialized HVAC equipment and a racking system. This lease contains a minimum of two components: The warehouse building and related HVAC equipment are a single component since their functions are intertwined, and the racking system is a second, since it is an asset controlled by the tenant that is not structurally integrated into the building. Depending on how the warehouse is situated, the leased land could be a third component; it may offer a distinct benefit and material value apart from the existing structures. We expect tenants, particularly those with multiple leased properties, to examine the functional integration of the various aspects of potential buildings during lease negotiations. All things being equal, we expect that they will favor properties with fewer, separate lease components, so as to simplify their accounting.
Many lease arrangements cover services provided by the landlord, such as janitorial, common area maintenance, or onsite IT support. These typically meet the definition of a “non-lease component,” since they do not grant the lessee control over a particular asset. Lessees must assign a value to non-lease components based on their relative standalone prices, or apply a practical expedient electing to account for the lease and non-lease components as a single liability. Performing an allocation may be time-consuming, but applying the practical expedient may result in a significantly greater balance sheet obligation. Lessors can expect increased scrutiny of the embedded service offerings in term sheets in upcoming lease negotiations.
While non-lease components are an accounting challenge for lessees, they also affect lessors. Revenues from services must be accounted for under the new revenue recognition model (ASC 606).
Lessees are assessing the long term effects of their current and future lease agreements. They are looking to mitigate reporting complexity, while avoiding adverse impacts on their debt covenants and financial results. Real estate owner/operators need to bring an understanding of ASC 842 to the negotiating table, too.
Please contact your Mazars USA LLP professional for additional information.