Lessors Take Note: FASB’s New Lease Standard Impacts You!

The Financial Accounting Standards Board’s (FASB) new lease standard is poised to have a huge impact on leases. Yet while plenty has been said about how lessees are affected, lessors in the real estate industry will also experience significant change— from possible revenue impacts and changes in operations and business practices, to changes in their financial statements and statement notes.

If you’re a commercial property landlord or lease equipment to other companies, read on about how the new lease standard could affect your business.

Impact on Your Operations

The new standard requires the majority of leases to be reported on balance sheets instead of in the notes, eliminating some of the accounting advantages of leasing. This might be an impetus for many companies to overhaul their real estate strategies, affecting a wide range of real estate/development professionals and related entities—from shopping centers that lease space to grocery stores and other large-box retailers to companies that provide forklifts, cranes and other heavy equipment.

Companies that traditionally lease property or equipment might choose to simply purchase these assets instead, leading to a possibly significant reduction in your revenues as a lessor. They might also want lessors to provide alternative lease structures such as shorter lease terms (with the intention to renew), variable rent, or contingent rent rather than leases with increasing fixed rent payments. The fixed rent payments determine the right to use asset required on a lessee’s balance sheet with the new statement.

Lessors in these cases should look at the structures of the leases they create and implement, so they can create leases that will encourage lessees to lease instead of buy these properties or assets. This will likely involve extensive changes in their accounting and control processes, as well as in the documentation of these leases.

While this is perhaps the biggest impact that the new lease standard will have on lessors (particularly in the real estate industry), this statement will affect lessors’ financial statements as well.

Recognizing Payments in Optional Periods

When determining the effects of a lease agreement, a lessor should include payments to be made in optional periods only if the lessee is reasonably certain to exercise an option to extend the lease (or not terminate it). Similarly, optional payments to purchase the asset should be included in the measurement only if the lessee is reasonably certain to exercise that purchase option.

A lessor should exclude most variable lease payments in determining the payment amounts, except for those that depend on an index or a rate or are essentially fixed payments.

Sale and Leaseback Transactions

Many sale and leaseback transactions involving real estate that previously would have qualified for sale and leaseback accounting under previous guidance will no longer qualify under the new lease standard.

For a sale to occur in the context of a sale and leaseback transaction, the transfer of the asset must meet the requirements for a sale. Per implementation guidance, if the leaseback is classified as a finance/sales-type lease, no sale has occurred. It also specifies that a repurchase option (that is, for the seller-lessee to repurchase the asset from the buyer-lessor) precludes sale accounting unless (1) the asset is nonspecialized and (2) the exercise price of the option is the fair value of the asset on the date the option is exercised.

If there is no sale for the seller-lessee, the buyer-lessor also does not account for a purchase. Any consideration paid for the asset is accounted for as a financing transaction by both the seller-lessee and the buyer-lessor. This could lead to a dramatically different result from expectations if the seller wants to report a gain on the sale, or if the buyer wants to report new assets held on its balance sheet.

Straight-Line Basis Leases

The lessors should continue to recognize lease income for those leases on a generally straight-line basis over the lease term. However, some changes to the lessor accounting guidance were made to align both of the following:

  1. The lessor accounting guidance with specific changes made to the lessee accounting guidance. This includes certain glossary terms that are applied by lessees and lessors.
  2. Key aspects of the lessor accounting model with the revenue recognition guidance. Leasing is fundamentally a revenue-generating activity for lessors. Whether a lease is similar to a sale of the underlying asset depends on (i) whether the lessee, in effect, obtains control of the underlying asset as a result of the lease, and (ii) a lessor is precluded from recognizing selling profit or sales revenue at lease commencement for a lease that does not transfer control of the underlying asset to the lessee. The lessor accounting model does not differentiate between leases of real estate and leases of other assets.

The consideration in the contract is allocated to the lease and non-lease components (for example, a service contract on a leased copier machine) in accordance with the allocation guidance for lessors. Consideration attributable to non-lease components is not a lease payment and, therefore, is not included in the measurement.

What do I do now?

Public companies will have to start complying with the new lease standard for fiscal years and interim periods beginning after December 15, 2018. Private companies have an additional year, with the standard taking effect for the fiscal years starting after December 15, 2019, and for interim periods within those years beginning after December 15, 2020. FASB will permit early application to report under the new rule.

It’s recommended that you consult with your CPA firm to get the information you need now, because implementation will require cataloguing existing leases and gathering data on lease terms, renewal options and payments. This could take considerable time and effort, depending on the number of leases, the inception dates, and the availability of records. In many cases, original records may be difficult to find or may not be available.

We can help you understand the new lease standard and the implications to your business, as well as help you consider the implications to your broader real estate strategy. Contact one of our real estate CPAs today for more information.

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