By now you’ve probably heard: Changes are coming to lease accounting. In this post, I will quickly go over what commercial leasing/tenant representation brokers need to know about the new lease accounting rules.
1. For starters, who does this affect? Does it affect all of my clients?
No. The new lease accounting rules will only affect tenants that have to issue “GAAP” financials. The companies that this will affect are primarily those that are publicly traded, or companies that are required to issue GAAP financials because of their bank loans. So your clients that are mom and pop stores, or single office locations, most likely will not be affected by these new rules. Simply ask your clients if they have to follow GAAP. Those that respond in the affirmative will be affected.
2. What about my clients that are landlords? Does this affect them?
No. For the most part, the new lease accounting rules do not affect lessor (landlord) accounting. Business for landlords will continue as usual.
Now a little History:
Now that we’ve discussed who this affects, let us go through some history to understand why the rules are changing. Under current lease accounting rules, most commercial leases are considered operating leases. When a tenant signs a 10 year operating lease, nowhere on the tenant’s financial statements does it show that the tenant has a financial obligation to the landlord for 10 years. Think about this, if you were investing in a company, wouldn’t you want to know what financial commitments (also called liabilities) that company has? That’s the point here. The accounting boards are changing the lease accounting rules so that those “rental payments” (also called rental commitments) are now reflected on the tenant’s financials. This is called “capitalizing” the lease.
3. What will be recorded?
So we now understand that the tenant will have to record these rental commitments on their financials. But what exactly do they record? Is it the entire rental payment, or only a portion? Under the new rules, ONLY the base rent portion of rental payments will be capitalized. CAM and everything else will not be included as part of the liability. So what the market refers to as “Gross” leases will need to be broken down under the new lease accounting rules. In other words, the portion of the Gross rent that represents the market base rent vs. the portion that is allocated to CAM and other operating expenses will need to be identified, and the portion related to base rent will be capitalized.
4. How (and why) will my clients need my help?
As I stated above, rental payments will now need to be allocated between true base rent and everything else. Most tenants will want the liability to be as small as possible, and as such, they will want the base rent to be as low as reasonably possible. This has to be within reason. You cannot, for instance, say Base Rent is $1/SF and CAM is $19/SF, because that would be deemed unreasonable. Actually the base rent should be based on the market, but once again that’s where your clients will need your assistance. Your clients will need you to be that trusted (external) resource to convince their auditors that the amounts allocated to base rent is appropriate. So as you negotiate the lease, you can specifically spell out the amounts related to base rent in the lease (or give your clients estimates of the base rent components of Gross leases) and as long as it is within reason of market rates, your client will be able to rely on those numbers for purposes of the new lease accounting rules. You, the brokers, are literally the most important resource for your clients as it relates to this information, and THEY WILL NEED YOU.
5. That’s great! So when are these new lease accounting rules supposed to kick in?
The Accounting Boards have stated the rules are supposed to become effective in December 2018.
editor's note: We have updated this post for clarity and accuracy as of February 2018.
6. Why not just wait until later this year to do anything?
For 2 reasons: First, companies have to issue what are called “Comparative Financial Statements.” What this means is that companies do not just issue financial statements for one year, they have to issue financial statements for the prior year as well. So even if the rules are effective in 2018, publicly traded companies will need this information for 2017 AND 2016 as well. 2016 is next year, so even though the effective date sounds far away, it is actually right around the corner when you consider the effect of comparative financial statements.
The second reason your clients cannot (and should not) wait is that leases that are being contemplated right now will definitely still be around when the new lease rules are in effect, and existing leases WILL NOT BE GRANDFATHERED. This means that the new accounting rules do not just affect leases signed AFTER the rules kick in, but ALL existing leases in effect at that time. So your clients need to be informed about how these new lease accounting rules will affect leases that are being contemplated, because the effects could be significant.
7. Are there any additional resources I can provide my clients to assist with this transition?
Yes! There is a FREE lease accounting tool that can show the effect of an existing (or contemplated) lease on a company’s financial metrics under the new lease accounting rules. Here is an additional resource discussing the capital vs. operating lease analysis tool. Simply enter the terms of the contemplated lease, and the system will display the effects of the lease on EBITDA, Net Income, Debt, Liabilities and Assets under the proposed new lease accounting rules. With this tool, your clients (specifically, your client’s accounting team) will be able to evaluate the effects of a lease under the new lease accounting rules, and with your help, they will be able to structure the lease based on the metric that matters to them. The analysis tool can be found here:
Once again, it’s free.
Thanks for the information, but why should we listen to you?
I graduated with a degree in accounting from the University of Georgia and passed all four parts of the CPA examination in my first try, back when you had to sit for all four parts at the same time. I worked for a public accounting firm specializing in audits of financial institutions (banks and insurance companies), and then worked in financial reporting – technical accounting and accounting research for a fortune 500 company for 6 years. As part of my work in accounting research, I have been following the new lease accounting rules for what seems like forever (because this is SUCH a big change, it is taking a while). Finally, I REALLY enjoy lease accounting. I’m not just passionate about it, I am borderline obsessed with it.
I currently work for LeaseQuery (LeaseQuery.com) which helps companies with their lease accounting. LeaseQuery is a tool that was designed from years of frustration dealing with existing software. I needed something robust yet simple and powerful yet uncomplicated. After realizing there was nothing in the market that met these requirements, we decided to build it. Simply put, LeaseQuery is the easiest, simplest, lease accounting software in the marketplace. Period.