One of things I’ve noticed when trying to explain the new lease accounting to real estate brokers, is they quickly get overwhelmed with the details. So I thought I would try to explain the effect of the changes in terms most real estate brokers would understand. The basic premise of the accounting change is to ‘improve transparency’ when reading a company’s financial statement (we’ll get back to this later). I believe most brokers know that a lease liability under the current lease accounting is not accounted for on the balance sheet (the balance sheet is the financial statement where you find what a company owns/assets and what a company owes/liabilities). Think about your first apartment lease, you paid rent each month over a period of months, you didn’t have to pay for the entire rent due up front but paid rent over the term as you ‘used’ the premises.
Then when you went to buy a car, the credit application only asked for your monthly rent, it didn’t ask how much rent you owe for the entire lease term. A company pays rent the same way and only records the rent payments when they pay them as an expense on their income statement. The total lease liability may be referenced in an annual report, but not referenced anywhere in a company’s financial statements, yet you get paid commission on the total value of the lease (most of the time up front), and the tenant is obligated to pay the landlord all the rent due according to the lease. So why is the lease not a ‘liability’ like a loan and not recorded on the balance sheet?
The Financial Accounting Standards Board (FASB) provides rules for accounting that align with GAAP (general accepted accounting principles) and in 1976 they published Financial Accounting Standard 13 (FAS 13) to provide guidance for the accounting of lease obligations. If a lease didn’t meet a ‘benefits of ownership’ test, then it was considered an ‘Operating Lease’ and FASB said all you have to do is expense the rent when you pay it. Why you ask? That’s because a lease transfers the right to use the space, but doesn’t transfer the benefits or risks of ownership.
The FASB did understand that certain lease structures can effectively provide the benefits of ownership and if the terms of a lease meet just one of the criteria contained in the ‘benefits of ownership’ test, then you would have to account for the lease as a ‘loan’ or ‘purchase money financing’. This is what is called capitalization of a lease. When large expenditures are made to acquire tangible assets to operate a business, they are referred to as capital expenditures and are added to the balance sheet as an asset. If debt was used to acquire the asset, then a corresponding liability would also be added to the balance sheet. So if a lease meets just one of the four criteria set out by FASB in the ‘benefits’ test you have to account for the lease as if you bought the property using 100% financing. This type of lease is referred to as a ‘capital lease or finance lease’ because you are capitalizing the lease just like a large asset purchase, creating an asset and liability on the balance sheet. So why is this bad thing? There are two primary reasons, depreciation and amortization.
Depreciation of an asset is almost always on a straight-line basis, meaning the asset value goes down the same amount each depreciation period. However, remember the first car loan you had, every monthly payment was the same as the one before but it all didn’t go towards paying back the loan, a portion of each payment is interest and each payment, you pay a little less interest and a little more principal, this is the result of amortization (paying the interest rate you agreed to only on the balance owed the bank after each payment, so the less you owe the less interest you pay each payment!). The problem here is the asset value goes down at a faster rate than the liability, so after you pay the loan down a bit, the balance sheet impact (where you find assets & liabilities) is the asset value is less than the liability even though they started at the same value. A capital lease has the same impact to a company’s financial statement. Can you imagine what your roommate would say if they thought they were just paying a month’s rent, but the total value of lease ended up on their credit report as a liability?
The new lease accounting basically puts all operating leases on the balance sheet as lease assets and lease liabilities…some place they have never been accounted for. This answers that nagging question, if they owe the rent, why isn’t the whole amount due listed as a liability? With the new lease accounting, the transparency the FASB was seeking related to lease liabilities will be achieved. Capitalizing a lease means that the value of the lease becomes both an asset and a liability. There are a number of technical issues associated with determining the net capitalized value of a lease; including the time value of money (discount rates), non-lease expenses (CAM), etc… just leave those issues to the experts. What you need to know is this creates opportunity for you to provide solutions. Guess what? Regardless of how a tenant accounts for their leases on their financial statements, you will get paid the same way you always have, based on the value of the lease. The accounting for the landlord is largely going to remain unchanged.