To err is human. To forgive is against company policy. Our last blog addressed how to Account for Lease Amendments that Expand the Leased Premises. In today’s article, we will explain the 6 common lease accounting errors we have found after reviewing thousands of leases.
One thing that makes LeaseQuery different from other lease management software providers is that we are not just real estate professionals; we are also accountants. Why is that important? Well, when you start using our software, we perform two tests on your leases to ensure the following:
1st Test: We make sure that you are making the correct payments based on the lease documents and,
2nd Test: We make sure that your existing leases are complying with GAAP.
While most of the existing lease software out there can perform the first test, the second assessment is more important because even though the correct payments are being made, the entries being recorded may be incorrect. Only accountants can make that determination.
In today’s column, we will show you the top 6 accounting errors we have found after our evaluation of numerous leases. Our discussion will address each of these common errors as follows:
1) First, we will state the error
2) We will explain the correct accounting treatment
3) We will describe the mistake we often see
4) We will evaluate the effect of the mistake on your financials (how it affects net income, EBITDA, etc; basically we will tell you why it matters) and finally,
5) We will demonstrate how LeaseQuery ensures this error does not happen.
Because we like to probe lease accounting problems comprehensively in our articles, this column will be divided into two parts: we will address errors 1 – 3 here, and errors 4 – 6 will be tackled in our next article. Additionally, download a copy of our lease accounting transition guide, so you can ensure you don't make these same errors yourself.
With that said, let’s delve right in. The first type of error we will address is:
1) Errors in accounting for tenant improvement allowances (TIAs):
Correct Treatment: When a lease contains a tenant improvement allowance, the correct entry is to record a liability for the allowance, and record a corresponding receivable upon executing the lease. The liability is straight-lined just like base rent starting from the possession date of the property as a reduction to rent expense, while the receivable is reduced when payment is received from the landlord (or when the landlord pays the contractor directly). Click here to read our article explaining the correct accounting for tenant improvement allowances, which includes a comprehensive example.
The leasehold improvement itself is recorded as CIP during the construction period, and is depreciated over the lesser of the life of the leasehold improvement or the remainder of the lease term, starting from the date the leasehold improvement is placed into service.
This is a VERY important point: the liability from the tenant improvement allowance is amortized starting from the possession date, while the leasehold improvement itself is amortized starting from the date the improvement is placed into service.
Mistake we often see: When a tenant receives a tenant improvement allowance, a lot of them do one of two things, both of which are wrong: they either do nothing at all, or they reduce the value of the leasehold improvement by the amount of the allowance.
We notice tenants tend to reduce the value of the leasehold improvement in situations when the landlord pays a contractor directly for the improvements rather than paying the tenant.
Why this is wrong, and the effect on your financials: According to GAAP, assets like leasehold improvements should be recorded at historical cost. If the tenant debits the cash received and reduces the value of the leasehold improvement (by crediting it), then the leasehold improvement is understated. If the leasehold improvement is understated, then the associated depreciation expense is understated, which means EBITDA is also understated.
We have heard the argument on more than one occasion that EBITDA would not be affected here, because the additional depreciation expense to be recorded is offset by the reduction in rent expense from the amortization of the liability from the tenant improvement allowance (if recorded accurately). There is a point here, but that point is not valid if the possession date of the property is different from the move in date.
As we stated in the “correct treatment” above, the liability is amortized starting from the possession date, while the leasehold improvement is depreciated starting from the date it is placed in service. As a result, there could be timing differences in EBITDA.
How LeaseQuery ensures this error does not happen: When a tenant improvement allowance is entered into LeaseQuery, the system automatically records a liability and amortizes said liability as a reduction to rent expense over the lease term. When our accountants reconcile your balances in your deferred rent account to the balances per LeaseQuery, (which they do for EVERY client), they will immediately identify the error in your books and give you the correct adjusting entries.
2) Errors in accounting for TIAs when a lease is renewed or modified:
Correct Treatment: When a lease is renewed or modified prior to the end of the initial lease term, then any unamortized tenant improvement allowance under the prior lease should be included in the calculation of straight-line rent expense for the new lease term. Basically, the amortization of the TIA (as described in the Error 1 above) should begin again as of the date of the renewal or modification, over the new term of the renewed or modified lease. Click here to read our article explaining Accounting for Tenant Improvement Allowances When a Lease Renews.
Mistake we often see: This is one area where we see the most errors. What we often see companies doing is…nothing. This is NOT GAAP.
Why this is wrong, and the effect on your financials: When companies do not make any changes to the TIA amortization schedules when a lease is renewed or modified, then rent expense is understated in some years and overstated in others. This has the reverse effect on EBITDA; it will be overstated in the years when rent expense is understated and vice versa.
How LeaseQuery ensures this error does not happen: When a lease with a TIA is renewed or modified in LeaseQuery prior to the lease term, the system automatically adjusts the amortization schedule starting from the renewal or modification date over the new lease term.
LeaseQuery indicates the lease has been renewed by highlighting the month of the renewal or modification in red, and includes the adjustment in the monthly journal entries it provides. See screenshot below.
3) Errors in accounting for prior deferred rent when a lease is renewed or modified:
Correct Treatment: Similar to tenant improvement allowances, when a lease is renewed or modified prior to the end of the initial lease term, then any deferred rent under the prior lease should be included in the calculation of straight-line rent expense for the new lease term. Click here to read our article explaining Accounting for leases when a lease is modified.
Mistake we often see: We often find that some companies make no adjustments to the deferred rent recorded from the prior lease. They just leave the liability on their books. The liability just sits on the balance sheet and keeps increasing as leases get renewed or modified.
Why this is wrong, and the effect on your financials: This is one error that you do NOT want to make, because the effect is ALL BAD. First of all, it increases rent expense on your financials, because the expense not reduced by the adjustment for deferred rent from the prior lease. This increase in rent expense in turn reduces EBITDA.
Finally, your liabilities are overstated because the deferred rent from the prior lease is not being amortized over the new lease. This exact situation caused an adjustment of $500,000 to one of our clients. It was a good thing we discovered it before their auditors did.
How LeaseQuery ensures this error does not happen: When a lease is modified or renewed in LeaseQuery prior to the lease term, the system automatically adjusts the deferred rent from the renewal or modification date over the new lease term.
LeaseQuery indicates the lease has been renewed or modified by highlighting the month of the renewal or modification in red, and includes the adjustment to deferred rent in the monthly journal entries it provides. See screenshot below.
Once again, this is the first of a two – part series explaining the 6 common lease accounting errors we have found after reviewing thousands of leases. Our next blog will address errors 4 – 6. Once again, At LeaseQuery, we do not simply provide lease management software. What we provide is peace of mind. With our software, you can rest easy knowing that not only are your lease payments accurate, but your lease accounting is appropriate. And if it isn’t, we’ll be the ones to let you know, not your auditors.
To read part 2 of the series, click here.
If you liked this post, then you will enjoy some of our other articles:
To get a free trial of our Lease Management Software, click here.