The Financial Accounting Standards Board issued its long-anticipated update to ASC 842 – Accounting for Leases, in February 2016. Tenants will see some significant changes to their financial statements after the 2019 implementation date.

The changes to the FASB guidance are sweeping, but their impact varies by industry. Landlords’ accounting will largely remain unchanged, but businesses that depend on leased space will face new complexities.

New Guidance

The new standards classify leases into finance and operating leases. Finance leases cover arrangements that: transfer control of assets at the end of their term, include purchase options, cover most of an asset’s useful life or involve highly specialized assets.

“The majority of commercial leasing transactions are expected to be classified as operating leases, since transfer of control is atypical, and spaces with custom build-outs can eventually be white boxed for new tenants,” Mazars USA Audit Manager Jason Gutman said.

Under the existing guidance, lessees recognize the expense of an operating lease ratably over its life. This “straight line” approach results in a more consistent bottom line.

Come 2019, in addition to reporting a straight line lease expense in their financial statements, tenants will need to recognize an asset and a corresponding liability on their balance sheets.

“One of the most significant sources of lessees’ off-balance sheet financing and risk is now front and center in their financial statements,” Gutman said.

Lease Classification

Finance and operating leases are initially accounted for as “right of use” assets, with a corresponding liability. The amount of the liability and the value of the asset are based on the present value of all future lease payments.

For tenants concerned with meeting debt covenants, a significant increase in liabilities may present challenges with lenders, according to Gutman. Seeking out shorter lease terms can benefit these types of prospective tenants.

Lease classification will also impact tenants’ debt service coverage ratios.

“In this respect, finance leases become a more attractive option for tenants, and they may be more aggressive in seeking out lengthier leases, build-to-suit arrangements and bargain purchase options,” Gutman said.

Variable Payments

The nature of lease payments will also impact tenants’ balance sheets. Variable lease payments are not included in the measurement of a lease liability and corresponding asset, since this liability is not fixed. Common examples of variable lease payments include rental increases based on the consumer price index or a percentage of retail sales. In both cases the tenant’s initial base rent may be the only payment that is fixed.

Because the liability associated with a fixed payment lease will generally exceed the liability of a lease based on variable payments, tenants may seek to negotiate greater variable terms in their lease payment structure to take advantage of this accounting treatment.

Lease Components

Commercial leases often include multiple, separate lease components.

“We expect tenants, particularly those with multiple leased properties, to examine the functional integration of the various aspects of potential buildings during lease negotiations,” Gutman said. “All things being equal, we expect that they will favor properties with fewer, separate lease components, so as to simplify their accounting.”

Non-Lease Components

Many lease arrangements cover services provided by the landlord, such as janitorial, common area maintenance or on-site IT support. These typically meet the definition of a non-lease component, since they do not grant the lessee control over a particular asset.

Non-lease components present accounting challenges for tenants and landlords. The latter must account for non-lease components under the new revenue recognition model, ASC 606.

Takeaways

As tenants evaluate their current and future leases, they will attempt to simplify their accounting while avoiding adverse impacts on their debt covenants and financial performance. Understanding ASC 842 is also critical for real estate owner/operators during negotiations.

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