Why you need to comb through your leases’ Operating Expense bills

Gone are the days when tenants could comfortably rely on their landlords to follow the leases when billing ancillary charges such as operating expenses, taxes and sundry charges.  In fact, as the real estate market has softened, landlords are devoting more time and resources to finding new and creative ways to increase revenue (See “Revenue Recovery” in Commercial Investment Estate Magazine).  As evidence of this, landlord-side audit programs have become more prevalent, and many tenants are being jolted by new and revised operating expenses bills that go back several years. 

Ironically, landlords have been successful at limiting their tenants’ reciprocal ability to review the accuracy of the charges.  Note that under the guise of granting their tenants “audit rights,” Landlords actually take them away!  Audit rights in leases are almost always more limiting than what the tenant can do in the absence of such rights.  Sending an incorrect bill constitutes a breach of contract, which gives a tenant the right to recover lease overcharges anywhere from 4 to 10 years, depending on the state.  (For a more detailed discussion of lease audit deadlines and other restrictions, see our LeaseTip™ – “Negotiating Lease Audit Rights.”). 

Now, more than ever, tenants should be reviewing their leases and bills to make sure they do not contain overcharges or errors.  Here are a number of important reasons why tenants should increase their vigilance with respect to operating expenses and other pass-through charges:

1. The onus is on you to point out errors.  

At the beginning of each year, landlords reconcile their buildings’ actual expenses with the estimated amounts paid by their tenants during the prior year. They then issue adjusting statements to settle each tenant’s liability and establish the new estimates for the current year.  Even though landlords must follow the leases when issuing these statements, they have no incentive to self-police their charges and place the burden on tenants to identify errors and bring them to their landlords’ attention.  If they don’t, the bills are considered conclusive and binding on the tenant.  What’s worse, tenants have a very short period of time to both identify and dutifully object to such errors; which brings us to . . .  

2. Time works against you.

Unfortunately, many tenants agree to lease provisions that provide very short windows (usually 30-120 days) and particular procedures (who can audit and how) to object to billing errors.  If the tenant does not object in time or does not follow the correct procedures, the statements are deemed correct and errors are no longer fixable.

 3.  You spend the time and resources to create a particular lease, but you don’t get the special treatment you deserve.

Although many commercial leases share a common basic structure, they almost always result in a labyrinth of unique terms and lists of conditional operations after the negotiation process is complete.  This time-intensive process can result in confusion and, in many cases, imperfect lease language.  What’s more, many landlords do not put in the time to tailor charges to each tenant’s lease, thus ignoring the particulars of their individually negotiated terms and instead following the building’s standard lease.  As you would expect, the standard terms inevitably favor the landlord.    

4.  Mistakes happen.

Due to the complexity that results from the negotiation process, it is common for tenants to be incorrectly billed.  In fact, over 85% of all commercial leases are being overbilled; if tenants are not comparing their individualized provisions to the landlord’s current billing practices, the chances are great that errors exist and that the tenant is paying for them.  

These errors can range from simple miscalculations to wholesale misinterpretations of lease language.  Many mistakes are unintentional; some are not.  In fact, many property managers just do not understand the nuances of what was negotiated because they were not a party to the deal and are rarely attorneys.  Regardless of the cause, errors can result in significant overcharges over time and, if not corrected, are assumed to be accepted and become embedded in the deal.  For examples of the types of errors that occur, see our list of Sample Issues.

5. Operating expense and tax pass-throughs are expensive.

Real estate can be one of a company’s most significant expenses, and commercial leases are one of its key components.  Up to 70% of the cost of a lease can represent the tenant’s obligation to share in building operating costs, taxes and utilities.

6.  Your landlord’s CPA’s certification doesn’t mean your bills are correct.

Even though your landlord’s CPA firm may have certified your landlord’s financial records, they never certify each tenant’s bill.  Furthermore, landlords’ CPA firms typically certify that the operating expenses are properly treated from an owner’s point of view for financial reporting or tax purposes, not from the point of view of a lease pass-through clause.  (For a more detailed discussion of lease audit deadlines, see our LeaseTip™ “A CPA Certification is Not Enough.”)  

What’s the fix?

Given the increasing prevalence and impact of overcharges, tenants need to review their leases and bills on a regular basis to make sure they do not contain such costly errors.  Taking advantage of the increased availability of affordable software designed to help manage leases and their related expenses will allow tenants to catch many of the errors before they agree to pay.  Another proactive way to circumvent these issues is to add a well-defined lease administration process.  If structured appropriately, a good lease administration team will add a new level of control over occupancy costs; especially when paired with a simultaneous lease audit function, adding an even deeper level of protection.

Andrew Zezas, President of Real Estate Strategies Corporation and president of SIOR NJ interviews Marc Betesh, President and CEO of KBA Lease Services, about upcoming FASB changes.

On July 21st, the FASB and IASB (collectively the “Boards”), verified our presumptions relating to the Leases topic- they will re-expose the lease accounting proposal containing their revisions and tentative decisions thus far.  Essentially, the Boards intend to give interested parties the opportunity to comment on the updated proposal, a process that began on August 17^th, 2010, with the publishing of the original Exposure Draft.  

Affirming the Boards’ intent to drastically overhaul the way leases are accounted for, Leslie F. Seidman, Chairman of the FASB  noted, “During our discussions of the extensive comments we received on the exposure draft, the boards have reaffirmed the major change to lease accounting, which is to report lease obligations and the related right-to-use on the balance sheet.”

The FASB website indicates that the new exposure draft will be reissued by Q4 of 2011.  Hans Hoogervorst, Chairman of the IASB, realizes the need for comment: “Although we have yet to conclude our deliberations on this project, the direction of travel indicates that there are aspects of our revised proposals that would benefit from additional input from interested parties.”  One thing weighing in favor of the Boards’ plan for a celeritous comment and deliberation period is the fact that over the last few months their re-exposure has, in retrograde fashion, moved closer to the original draft.  See our Lease Tips Article from July, 7^th.  Please stay tuned as we continue to follow the Boards’ deliberations.

For further details, periodically check the leases project sections of the IASB and FASB websites.

For the full press release please visit the  IFRS website.

Gross-ups are adjustments to building expenses that are made when such expenses are below normal levels due to building vacancies and other factors.

When buildings have vacancies, or one or more tenants perform certain standard building services themselves (e.g. nightly office cleaning), the mechanism in commercial leases designed to reimburse the landlord for operating expenses can malfunction. This may cause either undercharges or overcharges to the tenant, depending on the type of lease and the year in which the drop in expenses occurs. Gross-ups are intended to counteract this problem by adjusting expenses to the level they would be in a normal, fully operational building, with the landlord providing all standard building services to all tenants.

In most commercial leases, tenants are required to reimburse their landlords for their share of building expenses.  The reimbursement mechanism operates one of two ways, depending on the form of the lease:

• “Net” leases, in which the tenant is charged a percentage (based on its share of the total building area) of total building costs each year
• “Modified gross” leases, in which expenses are built into the rent (the rent is higher) and the tenant pays for its share of increases in expenses each year over the expenses for the base year.

For a full discussion of the differences between different lease types, see KBA’s LeaseTip™ entitled “Demystifying the Difference between Net and Gross Leases.”

When parts of a building are vacant or otherwise not receiving building standard services, the landlord’s operating costs for the building are less than normal.  This situation can be problematic when trying to calculate the proper share of building expenses for those tenants in occupancy and who are actually receiving all of the building services.

Grossing Up to Prevent Understated Tenant Reimbursements

If the reduction takes place anytime in a net lease, or in a year other than the base year of a modified gross lease, the tenant will pay less than its full share of expenses.  That’s because a reduction in overall expenses dilutes the tenant’s proper share of these costs.  Each tenant’s respective share remains fixed based on its percentage of the entire building, even though its actual share (based on only those tenants receiving services) may be higher.

Of course, calculating each tenant’s share as a percentage of occupied space, rather than total building space, could potentially fix this problem.  However, it is an imperfect solution because tenants in occupancy would have to pay disproportionate shares of fixed building expenses.  For example, a tenant who occupies 25% of a building, but due to vacancies is the only tenant in occupancy, would have to pay 100% of the expenses.  Thus, this single building tenant would have to pay 100% of landlord’s insurance costs for the property.

The better solution is to adjust the expenses to levels that would be present in a fully occupied building.  Here, in a building that is only 25% occupied, the property insurance costs would remain unchanged, but the abnormally low service costs, such as cleaning expenses, would be adjusted or “grossed up” to what they would be in a fully occupied building.  Now, the vacancy has no impact on the 25% tenant’s obligations.  Such tenant pays 25% of an undiluted amount – exactly what it would have paid had the building been full.

Every commercial lease should require that expenses be fully grossed up every year.

Grossing Up to Prevent Tenant Overbillings in Base Year Leases

Grossing up is especially important in base year leases to prevent windfalls to the landlord.  In modified gross leases with base years, the tenant is required to pay for all increases in expenses over the amounts incurred during the base year (typically the first year of the lease).  The idea is to provide a mechanism to protect the landlord against increases in costs due to inflation and other similar forces.  Each year, the building expenses are compared to what they were during the base year, and the tenant pays its share (based on its percentage of the entire building) of any resultant increases.  This mechanism keeps the landlord whole as costs rise.

If costs are suppressed during the base year due to building vacancies or other reasons, the base year will be abnormally low as compared to years where no such conditions exist.  If expenses thereafter increase to “normal” levels, when each year’s expenses are compared to the suppressed base amount, the increase for which a tenant is responsible becomes exaggerated.  This causes an annual overstatement of the tenant’s liability.

For example, if during a base year only 25% of a building needs to be cleaned, and the building fills up the following year, necessitating full cleaning, the cleaning expense will rise to four times its original level, even with no increase in cleaning rates by the vendor.  The tenant who occupies the original 25% will be required to pay 25% of this quadrupled increase.

Furthermore, because the base year expenses are used to calculate the tenant’s liability each year of the lease, this overstatement will occur every year of the lease term if the building remains fully occupied.  This creates an annual windfall for the landlord at the tenant’s expense.

To correct this, the base year expenses must be grossed up to normal full occupancy levels.  The low cleaning expense would be adjusted to what it would be in a full building, as should be done every year.  Then, if there is no increase in rates, the number will remain the same.  If rates increase, the number will rise accordingly.  Grossing up the base year expenses eliminates artificial increases and causes the expenses to rise only if normal market forces cause rates to increase.

Every base year lease should make a particular point to require that base year expenses be fully grossed up.

Fixed vs. Variable Expenses

Note that not all expenses vary in direct proportion to occupancy.  Many have a fixed component—a part that is unaffected by occupancy.  For example, while cleaning expenses may be highly variable, core building costs such as insurance or HVAC and elevator system repairs will not change significantly with variations in occupancy.  Each expense must be examined closely to determine if and to what extent a gross-up adjustment of the actual expense incurred is appropriate. 

The Building Owners and Managers Association (BOMA) has developed several suggested methods and calculations that some landlords are beginning to follow.  However, a landlord’s claim that it is following BOMA does not mean that its gross-up adjustments are correct.  BOMA has three different approaches to grossing up costs, and the one chosen by the landlord may not be appropriate.  Also, even though BOMA warns landlords to consider all of the relevant factors in performing gross-up calculations, many landlords simply follow BOMA’s generic formulas and forms without considering if they make sense in the circumstances.

Grossing Up for More than Occupancy

As mentioned above, occupancy is not the only factor that causes expense levels to be unusually low.  Warranty coverage of new building systems temporarily reduces maintenance costs and must be adjusted.  Also, in cases where management fees are calculated as a percentage of revenue, free and reduced rent periods will reduce management fees and must be adjusted to full rent levels.  Again, each expense must be carefully examined to ensure that these abnormalities are addressed to keep the pass-through/escalation clause operating as intended.

Conclusion

Grossing up is a necessary adjustment that should be required as part of the operating expense (as well as tax and utilities) reimbursement mechanism of every commercial lease.  It ensures that landlords receive full reimbursement of their expenses, and that tenants do not pay more than intended.

In a prior Lease Tips covering the forthcoming FASB changes to lease accounting, we reported that the FASB and IASB (the “Boards”) were more concerned with the quality of their final decision than the proposed timing.  According to industry chatter, it is looking quite likely that the Boards plan to ‘put their money where their mouth is’ as they continue to re-deliberate crucial issues based on the steady flow of industry opinion and data received from comment letters, roundtables and outreach initiatives.  This article will focus on some of the more substantive decisions made (or re-made) in lessee accounting to date.

Timing

For the better part of a year, the real estate community has been highly anticipating the pronouncement of the final standards by Q4 2011, subsequently to come into effect sometime in 2013.  Concerns surrounding the complexity of implementation have pushed the probable date back further to 2015.  However, there now is word that the Boards may take the Leases proposal down the same road as the Revenue Recognition project and re-expose the draft of the proposed new rules.  While this is not yet a certainty, a re-exposure would essentially take us back to day one and substantially elongate the implementation timeline.

One or Two Accounting Approaches for Lessees?

The Boards, after receiving many comments regarding this controversial portion of the proposal, had tentatively agreed to recognize the fact that not all leases are entered into as a financing vehicle for an asset purchase. Accordingly, they established two forms of leasing – “finance leases” and “other-than-finance” leases.  The latter, while not completely devoid of some financing element, recognized that the primary purpose of the lease is to create economic flexibility, such as to mitigate the risk of ownership and/or outsource significant activities principally related to maintenance and administration of an asset.

Perhaps the Boards felt that determining which leases were to be considered a finance-type as opposed to an other-than-finance-type was too onerous because, for whatever reason, they have reverted back to a single accounting approach for all leasing transactions.  This current approach, which is the same as the approach originally provided for in the Exposure Draft (“ED”), requires lessees to:

1. Initially recognize a liability to make lease payments and a right-of-use asset, both measured at the present value of the lease payments.
2. Subsequently measure the liability to make lease payments using the effective interest method.
3. Amortize the right-of-use asset on a systematic basis that reflects the pattern of consumption of the expected future economic benefits.

Because the liability will need to be amortized over the lease term like a mortgage loan, the annual interest expense is front-loaded, thereby requiring lessees to report higher lease expenses in the earlier lease years.

Options are In,  “More Likely Than Not” is Still Out

As previously reported, the Boards have recognized the near administrative impossibility of determining when it is “more likely than not” that an option will be exercised. To recap, the revised definition now reads:

“The lease term is the non-cancellable period for which the lessee has contracted with the lessor to lease the underlying asset, together with any options to extend or terminate the lease when there is a significant economic incentive for an entity to exercise an option to extend the lease, or for an entity not to exercise an option to terminate the lease.”

Therefore, at initial measurement and/or subsequent re-measurement, the determination as to whether a “significant economic incentive” exists will include, among other factors, the economics of the option compared to current market conditions, as well as whether significant commercially advantageous terms exist.

Reassessment

Reassessment of the lease term would only occur when there is a substantial change in relevant factors that would impact whether a lessee would have, or no longer have, a “significant economic incentive” to exercise any options to extend or terminate the lease. A lessee should take contract-based, asset-based and entity-based factors into consideration when reassessing whether a “significant economic incentive” exists.  These factors, when coupled with the tentative suggestion that in making this determination lessees should not consider changes in market rates after lease commencement, seems to suggest that the Boards are leaning toward a more subjective form of decision-making process – relying on external forces  as well as internal business decisions – as opposed to a more objective one whereby a “significant economic incentive” is measured by market forces and current pricing models (somewhat like valuing an “in the money” option).

In any event, this tentative modification to the ED would require a remeasurement of the asset/liability/income/expense in the first reporting period occurring after the “significant economic incentive” becomes apparent, notwithstanding that the lease required notice date has not yet arrived.

The Separation of Lease and Non-Lease Components

The Boards’ more definitive stance now dictates that an entity be required to identify and separately account for the lease and non-lease contract components.  Lessees are instructed to allocate payments as follows: if the purchase price of each component is observable, payments should be allocated on the basis of the relative purchase price of each distinct component; however, if purchase prices are not observable, all payments required by the contract should be accounted for as a lease.

The Boards have noted that, in consideration of the relevance of guidance in other projects such as revenue recognition, application guidance on how a lessee should determine what would constitute an observable price shall be provided.

When to Start: Inception versus Commencement

In response to questions concerning when to begin measuring lease assets and liabilities, the Boards have tentatively proposed that both lessee and lessor should recognize assets and liabilities (and derecognize any corresponding assets and liabilities) using a discount rate calculated at the date of lease commencement. The lessee should use the discount rate the lessor charges the lessee or, in the alternative, the lessee should apply its own incremental borrowing rate.

Furthermore, the Boards aim to capture Initial Direct Costs (those costs directly attributable to negotiating and arranging a lease that, but for the lease transaction, would not have been incurred) by requiring lessees to capitalize such costs by adding them to the carrying amount of the leased asset.

Lessees with leases which, at the date of commencement have a maximum possible term (including options to renew) of 12 months or less, need not recognize the lease asset or liability.  The Boards have tentatively decided that these short-term lease payments should be recognized in profit or loss on a straight-line basis over the lease term.

Looking Forward

While the ultimate decision may be a long-way off, there are sure to be more substantive changes, and changes to those changes, in the future; we will diligently keep you apprised of the path of the FASB/IASB Lease Proposal.

Duke Long interviews Marc Betesh about upcoming FASB changes at Corenet’s Chicago conference.

In prior Lease Tips about the forthcoming changes, we reported that the FASB and IASB (the “Boards”), promised to consider the numerous comments they received regarding the proposed rule changes detailed in their joint Exposure Draft (ED) dated August 17, 2010. That process is underway and significant positive changes to some of the more controversial and costly proposals have already been tentatively agreed to.

Lease Term to Continue to Include Options,  But on a Revised Basis 

The ED currently requires that the lease term include option periods if it is “more likely than not” that the options will be exercised. This determination would need to be made at lease inception and for each subsequent reporting period and the reported asset/liability/income/expense amounts changed when circumstances change affecting the prior determination. This would have caused an administrative nightmare and most of the determinations would be highly subjective, if not outright guesses.

When Options Would Be Included

Hearing the outcry, the Boards have tentatively agreed to the following revised definition regarding how the lease term will be determined by both lessees and lessors:

“The lease term is the non-cancellable period for which the lessee has contracted with the lessor to lease the underlying asset, together with any options to extend or terminate the lease when there is a significant economic incentive for an entity to exercise an option to extend the lease, or for an entity not to exercise an option to terminate the lease.”

Therefore, at initial measurement and/or subsequent re-measurement, option periods reasonably certain to be exercised should be included in the lease term. To make this determination, among other factors, the economics of the option will need to be compared to current market condition, and if significant commercially advantageous terms exist, the lease term should include the option period.

What remains unclear is whether this is a objective or subjective decision.  That is, is it that there is a significant economic incentive inherent in the option (does the option present a compelling incentive to be exercised because of market forces), or is it that it is reasonably certain that the lessee, given its business condition, will exercise the option.  We intend to further communicate with the Boards on this issue.

Frequency of Reassessment

The Boards also tentatively agreed that a lessee and a lessor should reassess the lease term only when there is a significant change in relevant factors such that the lessee would then either have, or no longer have, a significant economic incentive to exercise any options to extend or terminate the lease.

Therefore, it would appear that the goal of this modification to the ED is to only require the inclusion of lease options when the economic benefit of exercise becomes clear and is significant. These conditions may, or may not, present themselves prior to the date upon which the lessee must notify the lessor that the option is being exercised. In any event, this tentative modification to the ED would require a remeasurement of the asset/liability/income/expense in the first reporting period occurring after the significant economic incentive becomes apparent, notwithstanding that the lease required notice date has not yet arrived.

This revised definition of the lease term should significantly reduce the administrative burdens of complying with the new rules and make the determinations regarding exercising options more objective, as they will be based on changes in current relevant economic factors. 

Most Leases to be Considered “Finance” Leases and Capitalized

The ED currently considers nearly all leases to be finance leases, thus requiring the lessee to report a right-of-use (ROU) asset and liability to make lease payments on its balance sheet. Instead of annual straight-line rent expense being reported on the income statement, the ED currently requires the annual reporting of straight-line depreciation of the ROU asset plus interest expense for carrying the liability to make lease payments. But because the liability will need to be amortized over the lease term like a mortgage loan, the annual interest expense is front-loaded, thereby requiring lessees to report higher lease expenses in the earlier lease years.

The Boards received many comments regarding this proposal, as the front-loading of reported expenses [that, from a cash basis, is not actually occurring] could have a negative impact on many lessees, especially those in start-up situations. To address all the concern, the Boards have tentatively agreed to recognize the fact that not all leases are entered into to effectively finance an asset purchase. In these “other-than-finance” leases, although there is some finance element to the transaction, the primary purpose of the lease is to create economic flexibility, such as to mitigate the risk of ownership and/or outsource significant activities principally related to maintenance and administration of an asset.

To further recognize the distinction between a finance and other-than-finance lease, the Boards have tentatively agreed that the other-than-finance leases will not be required to report front-loaded income/expense in the earlier lease years, but rather show straight-line recognition similar to today’s “operating” leases. Although a right-of-use asset and liability to make lease payments will apparently still need to be reported on the balance sheet for these other-than-finance leases, the front-loaded interest expense problem will be eliminated.

How to determine which leases are finance-type, as opposed to other-than-finance-type, remains an open issue. The Boards tentatively decided to establish new indicators to distinguish a finance lease from an other-than-finance lease and their staffs are currently working on establishing these indicators.

The Separation of Lease Payments from Payments for Services Received

The Boards are still contemplating this issue. Current GAAP already requires the separation of all lease and non-lease cost components. However, during the recent FASB/IASB roundtables, investors/lessors appeared to favor the non-separation of service costs, while lessees favored the annual expensing of those service costs that are distinct and can be easily identified. A recent paper by the Boards’ staff indicates that this topic is currently being studied in greater detail and the staff’s recommendations regarding the appropriate accounting treatment for these service costs will be presented at future Board meetings.

We will keep you apprised of any further developments regarding this very important issue for the real estate industry.

Introduction

As a follow-up to our earlier Lease Tip, The Impact on Corporate Real Estate of Lease Accounting Changes under GAAP, we have compiled a list of the most instructive resources covering the effects of the proposed accounting changes by FASB/IASB.  

KBA is preparing comments for submission to the FASB/IASB boards.  Our focus is on the treatment of operating expenses and the inclusion of option periods in determining the length of leases.   Lend your support to KBA’s comments.  

Additional Resources

1. FASB Exposure Draft  and IASB Exposure Draft:   Exposure Draft of FASB’s proposed Accounting Standards Update of Topic 840 – “Leases”  and the Exposure Draft of the IASB, also entitled “Leases.”  Additional documents and resources from FASB/IASB:
             – Submit or read public comments to FASB          
             – FASB Summary of proposals contained in the Exposure Draft
             – Submit or read public comments to IASB
             – FASB/IASB Discussion Paper
2. FASB/IASB Webcast (Broadcast 10/28/10):  Larry Smith (FASB Board Member), Kevin Stoklosa (FASB Assistant Director), and Danielle Zeyher (FASB Project Manager) discuss the Exposure Draft and some initial stakeholder reactions gathered as part of the Boards’ outreach activities.  KBA has posted the slide presentation on its website here.
3. IASB Exposure Draft Snapshot Slideshow (08/2010): Provides an introduction and overview of the proposed IFRS on leases being undertaken jointly by the IASB and FASB.
4. Summary of project activities and decisions of the FASB and the IASB. FASB’s joint project on leases webpage, providing updates, timelines, due process documents, contact personnel and other links. 
5. Podcasts offered by FASB.  FASB member Leslie Seidman and FASB Project Manager Danielle Zeyher discuss the Exposure Draft on Leases. 
6. CoreNet Global presentation entitled “Space Matters: the Future of FAS 13- How the Proposed Changes will Affect Your Leased Portfolio Strategy” (09/19-21/2010): Slides from presentation by Richard Podos of Lance LLC and Russell Howell from Johnson Controls, Inc. at CoreNet Global’s Phoenix Global Summit. Summarizes strategic and operational implications and opportunities of the Exposure Draft on Leases.
7. Presentation by Ernst & Young, FASB / IASB Joint project on leases presentation to CoreNet New York City Chapter (10/20/2010):  Slides from presentation by Serena Wolfe, Senior Manager, NYC and Josh Herrenkohl, Senior Manager, NYC.  Excellent summary of key points for corporate real estate professionals. 
8. Suggested Comments to Proposed Lease Accounting Changes (09/21/2010): Suggested answers to questions posed regarding the proposed accounting changes. Taken from the Strategy Portfolio and Planning Community during CoreNet’s Phoenix Global Summit.
9. Article by Bill Early, SIOR, Copaken Brooks, “Upcoming FASB/IASB Changes to Lease Accounting Standards”: Thorough explanation of upcoming changes.
10. KBA Lease Services’ Lease Tip (9/15/2010): “The Impact on Corporate Real Estate of Lease Accounting Changes under GAAP”:  Concise explanation of proposed changes.   Part of KBA’s Lease Tip series.

If you know of additional resources on this topic and would like KBA to list them in this Index, please contact Lou Ferro, CPA, Sr. VP Audit Services, KBA Lease Services, lferro@kbalease.com or 888.750.4500 ext. 405.

Background of FASB and Lease Accounting Rules

The Financial Accounting Standards Board (FASB) is a private organization recognized by the United States government and the accounting world as the authority on accounting rules.  Since every company with publicly-traded stocks or bonds must comply with Generally Accepted Accounting Principles (“GAAP”), by default they must comport their accounting standards to FASB’s regulations.  The proposed changes to accounting for leases are a joint effort between the FASB and the International Accounting Standards Board (IASB).  FASB’s regulation of lease accounting was contained in FAS 13, issued in 1976.  Although FAS 13 has been “superseded” by the new FASB codification compiling all lease accounting rules and relevant guidelines in section ASC 840 (select the FREE basic view at the bottom of the page), the substance has remained materially the same.  The IASB’s corresponding lease accounting provision is found in IFRS 17.  There are some marked differences between the current ASC 840 (FAS 13) and IFRS 17’s treatment of leases; a clear comparison is available here.

KBA has received numerous responses to our latest Lease Tip, The Impact on Corporate Real Estate of Lease Accounting Changes under GAAP.  We are preparing to provide comments to the FASB/IASB exposure draft regarding the following aspects of the changes and would like to invite you to join us.

LET YOUR VOICE BE HEARD BY SUPPORTING THESE COMMENTS.  Enter your contact information in the form below.

Proposed Accounting Standards Update – Leases (Topic 840) – click here

Response to Question 6 (page 7): Contracts that contain service components and lease components

In most real estate leases, in addition to the liability to make the lease payments, lessees will also be liable for the costs to operate, repair and maintain the underlying leased asset, including annual operating expenses, real estate taxes and insurance costs (“Operating Expenses”).  In some leases these are referred to as “Common Area Maintenance.”  There are generally three types of real estate leases categorized by the extent to which Operating Expenses are included in the periodic lease payments. They are as follows:

A “NET” lease – no Operating Expenses are included in the periodic lease payments.

A “GROSS” lease – all Operating Expenses are covered by the periodic lease payments.

A “MODIFIED GROSS” lease – only the initial year’s Operating Expenses (the Base Amount) are included in the periodic lease payments.  After the initial year of the lease term, the lessee is liable to the lessor for the annual increase in Operating Expenses over the Base Amount. MODIFIED GROSS leases, are the favored form of lease commercial office lease in the United States.

The March 19, 2009 Discussion Paper on Leases, Chapter 9, sections 9.23 – 9.25 “Leases that include service arrangements,” discusses the requirement of current accounting standards that payments for services be separated from rental payments.

Is paragraph 6 in the “Scope” section of the Exposure Draft modifying the current requirement to segregate Operating Expenses in real estate leases?  If not, it would appear that the Operating Expenses under a GROSS lease would not be distinct and therefore the entire contract would be treated as a lease.

Although there is no easy way to segregate the service components from the lease components in a GROSS lease, in a MODIFIED GROSS lease the Operating Expenses are either specifically identified or can reliably be estimated at lease inception.  Thus, the service components and lease components can reasonably be and should be apportioned prior to measurement of the right-of-use asset and liability.

Please consider the foregoing and provide further guidance and clarification.

Response to Question 8 (page 8): Lease Term

The Exposure Draft proposes that the assumed lease term should be the longest possible term that is more likely than not to occur, taking into account the effect of any options to extend or terminate the lease. Regarding leases of real estate, if an entity is considered to be a going concern, why would the term used to measure the right-of-use asset and liability to make lease payments be limited to just option periods?  As a going concern, the entity’s real estate needs will not end after all options expire. They will continue perpetually into the future. If options are not exercised or a lease is simply allowed to terminate, the entity, still in need of real estate, will merely change leased locations (assuming it decides that leasing rather than purchasing is still the more favorable alternative).  As the specific location is not relevant to the measurement of the right-of-use asset and liability to make lease payments, then why is the assumed lease term limited by the contract terms for each specific physical location? And if the need to lease an underlying asset for a going concern is perpetual, how can the present value of the lease payments be determined? Finally, most negotiated options are merely used by tenants as leverage to renegotiate the terms of the lease when approaching the end of the stated lease term. Most options are not exercised exactly as originally negotiated.

Once one considers option periods beyond the term for which an entity is legally liable to make lease payments, why limit the assumed lease term to only those option periods stated in the contract? Perhaps the assumed lease term should be based on an entity’s long-term business plan and its estimated leasing needs to enable it to provide a particular market or region with its products and/or services. This approach de-couples the assumed lease term from a specific physical location and more closely matches the measurement of the right-of-use asset and liability to make lease payments to an entity’s underlying business needs. Of course, this approach will make estimating the relevant lease factors more difficult, as they will, in many cases, most likely extend far into the future.

Alternatively, perhaps the assumed lease term should initially be limited to periods only for which a legal liability to make lease payments exists. Then, when options are actually exercised or the lease terms are renegotiated, or the lease for the underlying asset terminates and the entity moves its operations to a new leased facility, the right-of-use asset and associated liability would be re-assessed at that time.

The commercial real estate industry is abuzz with the proposed changes to lease accounting under generally accepted accounting principles (GAAP).  On August 17, 2010, we moved one step closer to these changes with the joint release by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) of an Exposure Draft of such proposed changes.

Interested parties may comment on the proposed changes any time prior to December 15, 2010 and KBA intends to do so.  The Boards intend to finalize these new standards sometime during 2011, with possible implementation in 2013.  Whenever the actual start date, they will provide enough time to prepare for all the changes.

Why the Changes?

The Boards are trying to eliminate a “form over substance” distinction in GAAP accounting regarding typical, non-financing “operating” leases that has led to confusion and potential under-reporting in financial statements.  The Boards consider all leases, including operating leases, to be financially equivalent to purchasing the right to use an asset and financing it.

For example, the Boards see little economic distinction between a company entering into a long-term lease for a piece of equipment versus purchasing and financing it.  In both cases, the company is making periodic payments over an agreed time period for the right to use the equipment.  This is most obvious in the case of financing or “capital” leases, which are leases with very obvious purchase characteristics (e.g., the aggregate of the lease payments is similar to the purchase price and there is a purchase option at the end for nominal value).  Capital leases have long been treated as financed purchases under GAAP.

Real estate leases are no different than equipment leases and face the same form-over-substance issue.  There is little economic difference between leasing a building for 30 years versus purchasing and financing it via a 30-year mortgage loan. Like the equipment lease, in both cases, the company is making periodic payments for the right to use the building over 30 years.

Despite these economic similarities, under current GAAP, operating leases and financed purchases are treated very differently in financial statements.  Currently, lease payments made under operating leases (i.e., non-financing leases) are recorded as expenses on the income statement as incurred, and nothing is recorded on the balance sheet.  In contrast, for actual financed purchases and capital (financing) leases, an asset and corresponding loan is recorded on the balance sheet and depreciation and interest are recorded as expenses on the income statement. The carrying value of the asset is reduced each year as depreciation is expensed, and the loan balance is reduced as lease payments are made.

These differing treatments have lead to a lack of comparability and undue complexity.  In fact, many users of financial statements (lenders, investors, etc.) find themselves adjusting such statements to reflect the “true” assets and liabilities arising from operating leases.  The Boards believe providing for uniform treatment for nearly all lease transactions will provide reliable information that is useful to present and potential investors and creditors and other financial statement users in making rational investment, credit and other decisions.

What Will Change

In simple terms, the proposals would treat all operating leases like financed purchases, with the asset being the “right to use” the underlying leased asset for the lease term, and the liability being the loan value to finance that asset.  This is similar to the treatment of capital leases under current GAAP.

Thus, a 5-year lease for space in an office building would be treated as the purchase of the right to use the space for 5 years through a single up-front payment financed via a 5-year loan.

Life of the “Asset” and Length of the “Loan”

There is a wrinkle in the proposed changes, however.  As proposed, the life used to establish the asset value and the length of the loan would not be the actual length of the lease, but rather the longest “likely” length of the term, taking into account the likelihood of exercising options to extend or terminate it.  In other words, if a tenant has a 5-year lease with options to extend the lease for two additional 5-year terms, and the tenant believes it will most likely exercise the first option, then it must treat the asset life and loan period as being 10 years in length.

Furthermore, the proposal requires that the initially established asset values and loan amounts to be adjusted as and when the underlying facts or circumstances change.  In other words, if the tenant in the foregoing example changes its opinion and now believes that it will most likely exercise both options, it must recalculate the asset value and loan amount on its balance sheet assuming the 15-years term.

KBA is concerned that this variability will lead to confusion, complexity and possible manipulation, and might expose corporate officers to criticism if estimates prove to be incorrect.  Furthermore, those in corporate real estate negotiate options in their leases for flexibility, and disclosure of a company’s intention to exercise (or not exercise) an option has the potential to undermine its leverage in lease negotiations.

Treatment of Gross vs. Net Leases

The proposal will also require significant adjustments to the treatment of Gross and Modified Gross leases, which constitute the majority of commercial office leases in the US.

Commercial real estate leases contain two components:  the use of the space, which the landlord grants in exchange for rent, and the servicing of the space (the operating, maintenance, real estate tax and insurance expenses), for which either the landlord or tenant is responsible depending on the lease.  In pure Net leases, the tenant pays for the use of the space separately from the servicing costs, whereas in pure Gross leases, the rent covers both the use and servicing of the space.

Most commercial office leases are a hybrid of these two, and take the form of Modified Gross Leases.  In Modified Gross Leases, the initial rent covers the initial cost of the services, and the tenant reimburses the landlord for increases in services over time.  (For a more detailed discussion of Gross and Net leases, see KBA’s Lease Tip, “Demystifying the Difference between Net and Gross Leases.”)

Under the proposed changes to GAAP, it generally appears that the costs of servicing the space will continue to be expensed, whereas the cost of use of the space (i.e., the Net component) will have to be treated as a financed purchase.  For Net leases this will be relatively easy, given that these costs are already segregated.  However, for Gross and Modified Gross leases, a determination will have to be made to separate the two.

KBA intends to request clarification and guidance from the Boards regarding how to specifically handle the segregation of building service costs as part of gross and modified gross real estate leases.

Implications of the Changes

The proposed changes will eliminate off-balance sheet accounting, as they will require that the right-of-use assets associated with current operating leases be brought on to the balance sheet along with a corresponding liability.  Therefore, companies currently with significant operating leases will see a “gross up” of their balance sheets.

A company’s Income Statement will change as well and reported net income could be depressed in the early years of a lease, as recognition will change.  Straight-line rent expense will be replace with interest expense (for carrying the “loan” on the balance sheet) plus the amortization of the right-of-use asset.  Because the interest expense will be higher in the earlier years (like a mortgage), the total annual expenses will be front-loaded.

Lease renewal and contingent rents will need to be continually reassessed and the related estimates modified as facts and circumstances change.

The proposed changes will require significant systems and process changes to be in place by their effective date (pre-existing leases are not expected to be grandfathered) and will also require continuous monitoring of all lease transactions.

To avoid some of the negative effects of the new proposals, leases could become significantly more complex as landlords’ and tenants’ objectives diverge.  Tenants will be incentivized to sign relatively short-term leases; but this will be problematic for landlords that need to execute longer-term leases to satisfy lenders and investors.

KBA’s Thoughts

Does any of this make sense?  From a pure financial reporting perspective, probably so.  It puts all companies on an even playing field by establishing a consistent treatment for accounting and reporting their leasing transactions, regardless of what type of asset is being leased.  So whether a company produces spare parts for the automobile industry and leases significant amounts of its machinery to do so, or a nationwide insurance company leases significant amounts of office space in major cities around the country to house its employees, parties interested in these companies’ financial position and condition will be able to use reliable comparative data in their decision making process.

For tenants, especially those that lease relatively small portions of large buildings in various scattered locations, all this may seem antithetical to why they chose to lease their space in the first place.  If a company needs a limited presence in several locations, purchasing its real estate needs and operating each site is probably too costly.  Leasing space which is operated by the owner is much more cost-effective, as the company is only paying for what it uses and only for the time it uses it.  The company is not “buying” its space; in fact, the lease contract will specifically say that no ownership right is being transferred.  So why will an asset be shown on its balance sheet?  Also, the company is not borrowing money to make its monthly rent payments; those funds come from normal operating revenues.  So why must it establish an artificial “loan” and calculate annual interest expense?

The answer to those questions, simply put, is that the Boards believe the changes are necessary to properly recognize the fact that lease contracts represent long-term financial commitments that provide lessees with certain use rights and establish legal liabilities for future payments associated with those use rights.  If a lessee could, at any time, simply walk away from its rental obligations without legal consequences (i.e., no long-term commitments are established), perhaps the foregoing changes would not be necessary.  However, we know that this is not the case, and so it is the accounting profession’s responsibility to make sure that those financial commitments are properly and consistently reflected in companies financial statements.

How KBA Can Help

If enacted (which, as of this date, now appears likely), the new accounting rules will require significant analysis and complex calculations to properly report each lease transaction.  This will include:

• Determining the longest possible lease term that is more likely than not to occur
• Estimating rental payments during future option periods likely to be exercised
• Segregating the service portion of lease payments (i.e., the initial cost of operating expenses and taxes included in modified gross lease payments) prior to calculating the balance sheet liability
• Calculating the initial present value of the liability for lease payments, discounted using the lessee’s incremental borrowing rate or, if it can be readily determined, the rate the lessor charges the lessee
• Calculating the annual liability in subsequent years at amortized cost using the interest method
• Calculating the amortization expense for the right-of-use asset on a systematic basis over the expected lease term or the useful life of the underlying asset if shorter
• Performing annual reassessments of the carrying amount of the liability to make lease payments if facts or circumstances indicate that there would be a significant change in the liability since the previous reporting period

With over 25 years experience successfully analyzing and auditing all types of commercial real estate leases, KBA is in a unique position to support lessees’ efforts to comply with the new accounting rules.  If you need advice or assistance with the various assumptions and calculations necessary to convert your company’s current operating leases to the new accounting model recognizing a right-of-use asset and a liability to make rental payments, please contact us.