New Lease Accounting Rules and Their Effect on Lessee Balance Sheets
Last month, the Financial Accounting Standards Board (FASB) issued a new lease accounting standard that fundamentally alters how leases are recorded on a lessee’s financial statements. These changes to lease accounting could have a substantial impact on real estate transactions. The FASB issued this new standard in an effort to ensure that a lessee’s financial statements accurately reflect the fiscal impact of its leasing activity.
The new lease accounting standard applies to all companies that apply U.S. Generally Accepted Accounting Principles (U.S. GAAP). The new standard will be effective for public companies for fiscal years beginning after December 15, 2018, while private companies will have an additional year before the standard takes effect. This new lease accounting standard applies both to leases entered into after the effective date and also to existing leases. Companies will be required to apply the new standard to all leases as of the earliest period presented in their financial statements (generally a two-year look back).
Leases Are on the Balance Sheet
The new leasing standard significantly changes the lease accounting landscape for lessees. Under current U.S. GAAP, much time and energy is spent making sure that a lease is classified as an operating lease for the lessee so that the lease is off-balance sheet. Under the current rules, a lessee generally classifies a lease as an operating lease if the substantial risks and rewards of ownership remain with the lessor. With one exception, the new standard requires all leases to be recognized on the lessee’s balance sheet, whether they are classified as finance leases (currently referred to as "capital" leases) or operating leases. In other words, the classification of a lease will no longer have an impact on whether or not a lease is included on a lessee’s balance sheet. This new accounting standard represents a substantial shift in lease accounting with potentially significant financial statement repercussions for lessees, with an impact on loan covenants, debt service ratios and other financial requirements. To accommodate this shift, the lessee’s negotiating position in lease transactions will likely require adjustment. Lessees will focus less on the classification of the lease as an operating lease and more on how to minimize the impact of the lease on the balance sheet. Areas that lessees may focus on to lessen balance sheet impact include negotiating shorter lease terms, allocating more consideration to non-lease components and/or negotiating variable payments.
The new rules provide an exception for "short-term" leases, which are defined as leases with lease terms of 12 months or less. Although lessees may try to take advantage of the short-term lease exception whenever possible, this may prove very difficult in most commercial real estate transactions due to lessor financing concerns.
Payments for Non-lease Components Not Included in Lease Liability on Balance Sheet
Lease contracts often contain both lease and non-lease components. If a contract contains both lease and non-lease components (e.g., maintenance or management services), the contract consideration is allocated among the components and, generally, only the amount allocated to the lease components is included in the lease liability (and recognized on the balance sheet). Thus, lessees will be motivated to separate the non-lease components in a leasing transaction and allocate as much consideration as possible to those components. If the lessee is paying insurance and taxes (e.g., a triple-net lease), the payment of those amounts is included in the computation of lease payments unless the amounts are variable. This is a change from current U.S. GAAP, under which insurance and tax payments are not considered lease payments but are, instead, treated as executory costs.
Variable payments that are based on a rate or index are included in the lease liability (which is recognized on the balance sheet). However, variable payments that are not based on a rate or index (e.g., variable payments based on performance targets or revenue numbers) are not included in the lease liability unless they are considered in-substance fixed payments. A variable payment is an in-substance fixed payment if it appears to contain variability but, in reality, is unavoidable (e.g., a minimum payment). Regardless of whether it is probable that the lessee will make the variable payments (or whether the parties can reasonably estimate the variable payments), the lessee does not include those payments in the lease liability unless they are based on a rate or index or are in-substance fixed payments. Thus, a lessee may be motivated to negotiate variable payments to the extent possible.
Current U.S. GAAP contains detailed rules on sale-leaseback transactions that involve real estate (land, buildings and integral equipment). Much of this guidance is substantially changing. Under the new leasing standard, the determination of whether a "sale" has occurred will be governed by the new revenue recognition rules, i.e., the parties will identify a contract and determine whether control of the asset has transferred to the buyer by applying the transfer of control criteria in the new revenue standard. If control of the asset has been transferred, there is a sale for financial accounting purposes.
The new rules provide that the existence of the leaseback, in and of itself, will not preclude sale accounting. However, if the leaseback would be classified as a finance lease by the seller/lessee or a sales-type lease by the buyer/lessor, control has not been transferred to the buyer and there is no sale for financial accounting purposes.
Under the new rules, in the context of a sale-leaseback of real estate, sale-leaseback accounting is not available if there is a seller/lessee repurchase option – even if the option is a fair value option. This is a change from current practice and is also inconsistent with tax law, which allows the option as long as it is not a bargain purchase option. Under the new rules, a failed sale-leaseback will be accounted for as a financing by both parties.
A seller/lessee also needs to be careful with respect to any residual value guarantee. If the seller/lessee provides a significant residual value guarantee, the risks and rewards of ownership may not have transferred to the buyer/lessor. The transfer of risks and rewards is only one factor in evaluating the transfer of control, but depending upon the application of other facts and circumstances (e.g., lack of physical possession), the existence of a significant residual value guarantee may preclude sale-leaseback accounting.
With respect to gain or loss recognition on a sale-leaseback, current rules generally require gain deferral (with recognition over the lease term). In contrast, the new leasing and revenue recognition rules generally require upfront gain recognition on the sale portion of the transaction.
Under many circumstances, entities will continue to decide that, economically, leasing is the preferred way to gain use of an asset. Although the changes in the lease accounting rules may not ultimately drive the decision to lease or purchase, they will likely drive changes in the structure and terms of lease transactions. Commercial lessees will come to the table with a different set of goals in mind. Meeting these goals will depend upon a firm understanding of the new rules and creativity in negotiating ways to minimize any negative impact on the financial statements. Practitioners must be mindful of the new rules when negotiating and structuring leases and should carefully analyze existing leases to determine how the new rules will apply and whether re-structuring is necessary or advantageous.