2019 is a big year in lease accounting. In 2019 (which began December 15, 2018 for fiscal year reporters), publicly traded companies are required to comply with the new accounting standard (ASC 842) and are required to recognize leases greater than 12 months on their balance sheet. In 2020 (beginning on December 15, 2019 for fiscal year reporters), all other entities (i.e., private companies including non-profits) will be required to comply with this new standard. It is expected that over $2 Trillion will be transferred to US companies’ balance sheets. As I previously wrote (Lease Accounting Change Gets the Go-Ahead ), financial transparency is the driver of this new standard which was developed in the wake of the great recession. “We believe that this new standard is important because it will provide investors, lenders and other users of financial statements a more accurate picture of the long term financial obligations of the companies to which they provide capital,” said FASB Chairman Russell G. Golden. Now that it is official, in this post I highlight what office tenants should be doing to comply with this new standard. I am joined on this post by Mirela Gabrovska of MBG Consulting, a national expert in lease administration and auditing.
Pre-ASC 842 Accounting Treatment.
Most office leases are treated as “Operating Leases” (as opposed to “Capital Leases”) and are not recognized on the balance sheet. Instead, they are recognized annually on a straight-line basis as a rent expense on the income statement. Leases are considered “Capital Leases” by meeting at least 1 of 4 criteria (articulated by FASB) which is tantamount to a financing transaction. Capital Leases are recognized on the Balance Sheet as an asset and liability.
ASC 842 New Lease Accounting Treatment.
All leases (excluding those 12 months or less) will be recognized on the Balance Sheet as: (i) Asset of “Right-of-Use” measured as present value (using tenant’s incremental borrowing rate) of all future lease payments plus any initial direct costs (including prepaid rent) incurred by the Tenant; and (ii) Liability of corresponding “Obligation-to-Pay” measured by the present value (using tenant’s incremental borrowing rate) of all future lease payments where the lease payment is divided into amortization and interest expenses. Note, while tenants with leases of 12 months or less can elect not to recognize it on the Balance Sheet, they should recognize lease expense on a straight-line basis over the term.
What Should Tenants Do?
- Lease Abstract – have your advisors, review and abstract your leases of all relevant information to assess the lease liability under ASC 842. Key elements include commencement date, expiration date, tenant improvement allowances and expenses, free rent, all rental charges including operating expenses, taxes, utilities , and security deposits. You will also need to determine indirect costs paid to brokers and lawyers, and possession dates for premises occupancy. This is also relevant if you have any subleases or lease any of your owned property to third parties.
- Lease Options – your options to renew, expand, contract and/or terminate may affect the valuation based upon the likelihood of those options being exercised. You need to ascertain the future rents to determine future liabilities which can be a “crystal ball” exercise as most renewal options are based upon “fair market” value.
- Uniform Accounting Policy – determined by the internal technical accounting team in conjunction with the internal and external audit team, create all guidelines defining assumptions, criteria, process, etc. for lease accounting treatment.
- Determine Discount Rate – when calculating the present value of your lease payments, you must determine your discount rate which is based upon your borrowing rate.
- Exchange Rates – you will need to make decisions on what exchange rates to use – functional currency, currency per lease, reporting currency, etc. and how these rates are to be documented.
- Future Lease Negotiations – where you have leverage, explore ways to restructure your lease so that you are not capitalizing unnecessary costs that increase your liabilities, i.e., separate treatment of expenses from rent.
- Review Impact on Company’s Debt Ratios – as real estate leases are typically the largest lease cost for companies, their transfer to the Balance Sheet may increase the debt ratios of some companies and have an unintended impact on its existing debt agreements. You may wish to discuss this with your lenders.
- Lease Administration Program – for tenants with a large number of leases, they will want to be sure that their accounting systems and lease administration are ASC 842 compliant.
- Audit – hopefully your lease provides you with audit rights. Consider an audit to be sure that you are not capitalizing more costs than are necessary and are not being overcharged per the terms of your lease. See my post – Limiting the Hidden Costs of Office Rent: Operating Expenses & Taxes.
We welcome your questions.
Don Wenig – (312) 345‐4778 – firstname.lastname@example.org
Mirela Gabrovska – (312) 216‐2525 – M.Gabrovska@MBGConsulting.com