By Shahab Moreh
The proposed accounting standard related to accounting for leases has been the subject of controversy and criticism from landlords, tenants, other lessors and lessees.
That is because the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are working on a joint project to create a common lease accounting requirement that would require assets and liabilities arising from all lease contracts to be recognized on the balance sheet.
The proposed accounting rule currently considers all leases to be financing leases, and would require tenants to report an asset for the right-to-use the premises and a corresponding liability for their obligation to pay rent.
The balance sheet of many tenants would be affected because significant lease obligations currently not recorded on the balance sheet would be reflected as a liability on the balance sheet.
This treatment would not only bring an end to off-balance sheet financing for all leases but would also require tenants to report higher expenses in earlier years because the liability, similar to a mortgage loan, would be amortized over the lease term, while the annual interest expense for carrying the liability plus expenses related to the depreciation of the right-to-use asset is front-loaded.
This is different from the current accounting treatment of leases whereby rent is reported ratably on the income statement over the term of the lease.
Now the Boards are acknowledging that all leases are not necessarily created with the same business purpose and intent, therefore, there is good rationale to distinguish between two types of leases. The Boards are now considering a different treatment for a structure that is a “finance lease” compared to “other-than-finance” lease.
Apparently, after receiving numerous comments from the public, the Boards now see the difference between a lease that is created to provide economic flexibility to the lessee to mitigate the risk of ownership compared to a real purchase of an asset financed by a lease structure.
A “finance lease” would be treated like a purchase, which would reflect an asset on the balance sheet, and a corresponding liability to finance the purchase. Although, a right-to-use asset and corresponding liability to pay lease payments for “other-than-finance” leases would still be reflected on the balance sheet, such leases will not have to record front-loaded income and expenses during the earlier lease years. Instead they would reflect rent expense pro-rata over the term of the lease similar to what is known now as operating leases.
In addition, the Boards have relaxed their position on several aspects of the proposed lease accounting rules.
With respect to including extension and early renewal options in lease assets and liabilities, the Boards are considering that these options would only be included if there is a “significant economic incentive” for the tenant to exercise such options.
This is dramatically different from the prior proposal, which required these types of options be included in determining the lease term if the options were “more likely than not” to be exercised by the tenant.
The less stringent approach would benefit the tenant, because a lessor’s liability would not be recorded on the balance sheets, to the extent that such options don’t meet the “significant economic incentive” criteria. Factors such as renewing below market rents, or the tenant’s rights to significant tenant improvement allowances upon the renewal term would be the type of factors that tenants would have to consider to evaluate whether options in their lease should or should not be included in determining the appropriate term of the lease.
The wild card will be whether or not real life circumstances such as cost or difficulty to move, or if the reputation established by a tenant while conducting business from a particular location, would constitute a “significant economic incentive.”
Further, instead of requiring tenants and landlords to reassess inclusion of option terms at the end of each reporting period of a financial statement, the Boards are considering allowing tenant and landlords to reassess the inclusion of option terms only when there is substantial change to factors relevant to the original evaluation of the “significant economic incentive” test performed to determine if an option will or will not be exercised.
There is also some relief for tenants (in particular retailers) and landlords affected by leases subject to variable payments, such as rents that are dependent on percentage of sales or rents subject to CPI rent increases.
The Boards are considering guidelines that these types of lease payments should only be included in the determination of lease assets and liabilities if they are reasonably certain to be received or paid. Therefore, any lease subject to an index or leases which have variable features that are reasonably certain to lead to additional rent would be included. Under the original proposed standard, landlords and tenants were required to estimate any amounts of variable lease payments.
The debate will now be 1) how to determine whether a lease is a “financing lease” or an “other-than-financing” lease, 2) factors to consider in evaluating “significant economic incentives” and 3) determining the extent of variable lease payments to be realized by tenants and landlords.
Shaheb Morah is a partner at WeiserMazars LLP.
