Lease Accounting – Some Gotchas

As the FASB and the IASB slowly inch through their long-standing leasing project that will, in all likelihood, move all leases longer than one year to the balance sheet, it doesn’t mean that current GAAP requirements for leases don’t present some challenges, even for simple office facility leases.

Given that FASB No. 13, the pronouncement that established most of the GAAP literature for leases we still use today, was issued in 1976, it’s not as if this area of accounting should contain many surprises.  But, oh, it does…

Lease Accounting

About a year ago, a client called me wanting to discuss the accounting for a lease settlement his company received from the current landlord.  It seems the landlord wanted the company to leave its facility by the end of 2013, but the company’s lease did not expire until during 2015, so the landlord was willing to pay a nice sum of money to get the company out early.

Although I thought I knew the answer to this question, when I consulted the GAAP literature, I discovered that I was thinking of the more normal situation (at least historically) where a new landlord induces a company to break a lease to leave early, rather than when the old landlord wants to break the lease.  It turns out that GAAP is not so clear in this reverse situation.

This reminded me of some of the less than straightforward provisions of lease accounting that bear consideration when negotiating a lease, and some of these provisions seemingly will not go away after the new lease accounting standard is finalized, which will likely be later this year.

Straight-Line Lease Payments

Many, if not most, leases these days offer free rent periods (so many months at the inception of the lease or at various intervals throughout the lease). Leases also commonly require payments that graduate upwards as the lease progresses. Some people even know that lease expense should be recorded on a straight-line basis over the lease term, instead of according to the lease payments actually due under the lease. But, did you know…

…that if the landlord grants access to the new facility before the inception of the lease term, that early access period must be added to the contractual lease period for purposes of the straight-line rental calculation?  This generally results in a higher amount of rent expense being recorded in early periods, even though no actual payments are due to the landlord then.

Asset Retirement Obligation

What is this? It doesn’t sound like it has anything to do with lease accounting, and it doesn’t. Even so, asset retirement obligations are often recorded in conjunction with a new lease, especially when a company is leasing a facility that needs significant modification to meet the company’s business needs.

Many leases require that a tenant restore leased premises to a neutral state upon vacating the facility.  Say, for example, your company has a production process that requires specialized improvements that likely would not be needed or desired by another tenant. Odds are good that the lease agreement will contain wording that requires the company to remove the specialized improvements at the end of the lease.  This same provision often extends to computer network cabling and other improvements, and sometimes the costs of reinstating the property to a “before-lease” state can be significant.

Accounting rules require the company to record an “asset retirement obligation” at the start of the lease for the costs required at the end of the lease.  The estimated present value of the future payments required to fulfill this lease obligation is recorded as an asset, with a corresponding liability, at the inception of the lease.  The asset is then amortized over the lease term as, effectively, additional depreciation expense. The discounted liability is accreted interest expense over the period of the lease, so that the ultimate obligation recorded on the books should cover the costs needed to re-instate the facility to its original condition at the end of the lease.

Lease Incentives

As I noted above, the most common lease incentives occur when a new landlord covers certain costs of a move to that landlord’s facility.  These costs might be characterized as reimbursements for abandoning leasehold improvements, assumptions of obligations under the old lease, reimbursements of moving costs, and the like.  GAAP is straightforward in requiring that these types of relocation costs covered by the new landlord be spread over the term of the new lease as reduced rent expense, rather than recognized as gains earlier.

But what about the situation described above that got me thinking about these quirks of lease accounting in the first place?  Here’s what we ended up deciding to do about the old landlord’s incentive to move out:

  1. Allocate a portion to offset the incremental amount of lease payments required under the new lease over the old lease through the remainder of the old lease’s term, so that the company recognizes rent expense for the new lease as if it would have under the old lease, even though it will be paying more to the new landlord.
  2. Allocate additional amounts to offset current costs associated with the move itself.
  3. Amortize the remaining amount of the lease incentive payment from the old landlord, as if it was a lease incentive under the new lease, over the term of the new lease.

Others might have come up with different accounting schemes for this lease incentive. This situation merely illustrates that lease accounting is not always as simple as it might seem, and “gotchas” can pop up where you least expect them.