Following a series of corporate accounting scandals in the early 2000s, Congress passed the Sarbanes-Oxley Act of 2002 (SOX). Section 401(c) of SOX required the Securities and Exchange Commission to study and report on the extent of off-balance transactions. This prompted the Financial Accounting Standards Board (FASB) to undertake a project on lease accounting.
On February 25, 2016, FASB issued an Account Standard Update (ASU) called ASU 2016-02 (codified as ASC 842) in order to increase transparency and accuracy in financial reports requiring entities to recognize operating leases greater than 12 months on the balance sheet. ASC 842 replaced the 40-year-old lessee accounting model ASC 840, making several changes, with the primary goal of eliminating an accounting loophole that allowed recording off-balance sheet operating leases in the footnotes of financial statements.
Monumental change for lessees: operating lease liability
The most significant change under ASC 842, is the requirement for lessees to recognize operating leases as a right-of-use asset (ROU), and lease liability on their balance sheets, amortized over the length of the lease. An estimated $2 Trillion of lease liability will be added to S&P 500 balance sheets (offset by the recognition of the right to use assets) as a result of the new guideline.
On income statements under ASC 842, lessees will recognize the lease as an operating expense amortized on a straight-line basis.
Lessors, don’t overlook the new definition for ‘lease’
The effect ASC 842 has on property owner accounting isn’t as severe as it is for tenants. However, there are various modifications in the update that will impact commercial real estate firms: leasing, administration, management, tenant relations, financial reporting and disclosure procedures.
Property owners should pay attention to ASC 842’s updated definition of a lease and guidance on separating lease and non-lease components, which may impact lessor accounting. Lessors should also make sure that operating leases are recognized in financial reports on a straight-line rent basis (unless another systematic and rational basis is more appropriate).
Commercial Real Estate owners and managers should review the implications of ASC 842 with their CPA firm to make sure they are in compliance, and to help them navigate through the transition. Certified Public Accountants will be able to guide lessors on how they should account for lease modifications, build-to-suit transactions, broker-owner transactions, and revenue recognition.
Brokers, owners, & property managers, get ready for tenant lease negotiation
In addition to staying in compliance with the Accounting Standard Update, property owners and managers should be aware of the impact ACS 842 will have on their tenants and prospects when negotiating lease agreements. Since tenants will now have to account for operating leases on their balance sheets as a liability, this may create problems for them to acquire loans. Shorter-term leases will become more attractive to retail, office and industrial tenants, since it will lower their overall liability, and commercial leasing teams should prepare themselves for negotiating lease terms.
Furthermore, since operating lease expense will be calculated on a straight-line rent basis, a tenant’s debt service coverage ratio will be affected. However, with a finance lease, interest and amortization are the only two expenses, and this could make finance lease options more appealing to prospective tenants.
The new standard may require lessees to reevaluate their lease agreements, and look to their landlord for assistance in order meet the new guidelines.
Transition timeline for private companies
For public companies with a December 31 year-end, the new guidance is already in effect (as of January 1, 2019), and March 31 will be the first quarterly reporting date using the new accounting standard. For private companies, ASC 842 will go into effect in annual periods beginning after December 15, 2019.
The good news: process improvements in lease administration and accounting
In addition to FASB’s stated goal of increasing transparency and comparability among organizations, there are additional indirect benefits from the update. In order for businesses to stay in compliance, they must audit, analyze and revise their business processes to ensure lease management, document management, and accounting workflows are running efficiently, and in tight control.
Property management firms can stay in compliance with (and stay ahead of the curve) by selecting the right technology platform that will enable them to perform: advanced accounting, commercial lease administration, customized financial reporting, CAM billing & reconciliation as well as straight-line rent reporting. When selecting an integrated Accounting & Lease Administration Software provider, it’s important to make sure they are SSAE18 certified and compliant.
SKYLINE helps landlords stay in compliance and improve internal controls
SS&C’s property management, accounting, lease management, and financial report solution, SKYLINE has been designed for quick and easy implementation and makes compliance with current and future changes to accounting requirements, simple and intuitive.
SKYLINE’s comprehensive Straight-Line Rent (SLR) reporting feature allows lessors to configure existing leases, set up new leases and easily retrieve critical lease information to meet monthly reporting requirements for investors by delivering timely, accurate financial reporting.
SKYLINE software provides detailed impact analysis including cap rate calculations, lease build-outs, and projected deferments and more.
Real Estate & Property Management