How to Transition From Current to the New Lease Accounting Rules

Transcription

1 How to Transition From Current to the New Lease Accounting Rules This week s blog is a comprehensive example explaining how to transition from current GAAP to the new lease accounting standards. We will be using a real life scenario that one of our clients graciously allowed us to use as an example. We have a lot to cover, so let s get right to it. Assume a Tenant signs a lease document with the following predicates: Lease Term: A term commencing on April 1, 2016 (Commencement Date) and continuing for one-hundred-twenty (120) full calendar months. Tenant shall be granted access to the Premises sixty (60) days prior to the Commencement Date to install equipment and furnishings (the Early Access Period ). Such access shall be subject to all the terms and conditions of this Lease, except that the Commencement Date and the payment of Rent shall not be triggered thereby. TI Allowance: The tenant received a Tenant Improvement Allowance of $1.2 Million as an incentive to sign the lease from the landlord. The landlord paid the contractor directly for the construction of the Improvements. The improvements were constructed prior to the Early Access Period. Moving s: The tenant also received a reimbursement of $30,000 in moving expenses from the landlord. Base Rent: Per the lease document, the rent commencement date is 3 full calendar months after the tenant opens for business at that location. Base rent is $205,000/month; with annual increases on the anniversary of the rent commencement date of 3%. Assumptions: Assume that the lease is classified as an operating lease, assume that the tenant is a public company, assume that the rate inherent in the lease is unknown, and the fair value of the building is $300 Million. Assume the Tenant opened for business at the location on June 1, Assume that if the company tried to borrow $300 Million (to purchase the building) its borrowing rate would be 9% in 2019, but if the company tried to borrow $27 Million (the amount of the total lease payments) its borrowing rate would be 6% in 2019.

2 Here are the steps to take to transition from Current GAAP to the new lease accounting standards issued by the FASB: Step 1: Determine the lease term under current GAAP. The lease term stated in the contract is 120 months, however the document states that the tenant shall be granted access subject to all the terms and conditions in the lease document during the Early Access period. Assuming the early access period started on February 1, 2016, then for GAAP purposes the lease really started on that date, and the lease term is actually 122 months; from February 1, 2016 through March 31, Step 2: Determine the total lease payments under GAAP. The rent commencement date is September 1, 2016 (3 months after the date the tenant opened for business). The total lease payments are $26,863,751. Step 3: Prepare the Straight-line amortization schedule under current GAAP. The lease term is 122 months (from Step 1), total rent is $26,863,751 (from step 2). Monthly rent expense from base rent is therefore $220, Note however, that there is a total Incentive of $1,230,000 ($1.2 million in TI Allowances and $30,000 in moving expenses). These incentives have to be amortized over the lease term as well, which results in a monthly credit to rent expense of $10, As a result of the incentive adjustment, total rent expense on the income statement is $210, Please see below for an illustration of the straight-line amortization schedule. Note that this data is directly from our Lease management software. Note that the tenant will use this amortization schedule to make entries through the effective date of the new lease accounting rules.

3 Year Month Cash Base Rent Cumulative Deferred Rent Unamortized TIA Balance Incentive Adjustment Total 2016 February - 220, (220,194.68) (1,219,918.03) (10,081.97) 210, March - 220, (440,389.36) (1,209,836.07) (10,081.97) 210, April - 220, (660,584.04) (1,199,754.10) (10,081.97) 210, May - 220, (880,778.71) (1,189,672.13) (10,081.97) 210, June - 220, (1,100,973.39) (1,179,590.16) (10,081.97) 210, July - 220, (1,321,168.07) (1,169,508.20) (10,081.97) 210, August - 220, (1,541,362.75) (1,159,426.23) (10,081.97) 210, September 205, , (1,556,557.43) (1,149,344.26) (10,081.97) 210, October 205, , (1,571,752.11) (1,139,262.30) (10,081.97) 210, November 205, , (1,586,946.78) (1,129,180.33) (10,081.97) 210, December 205, , (1,602,141.46) (1,119,098.36) (10,081.97) 210, January 205, , (1,617,336.14) (1,109,016.39) (10,081.97) 210, February 205, , (1,632,530.82) (1,098,934.43) (10,081.97) 210, March 205, , (1,647,725.50) (1,088,852.46) (10,081.97) 210, April 205, , (1,662,920.17) (1,078,770.49) (10,081.97) 210, Step 4: On the effective date, determine the total payments over the remaining lease term under the new lease accounting standard. Under FASB s new lease accounting standard, the effective date for public companies is January 2019, and the remaining lease term starts from the earliest comparative period presented. Public companies issue 3 income statements and 3 cash flow statements, as such the earliest comparative period presented would commence on January 1, The total remaining payments from January through March 31, 2026 is $26,043,751.

4 Step 5: Calculate the present value of the remaining lease payments (the lease liability). Under the FASB s new lease accounting standard, the company would need to calculate the present value of the remaining lease payments from the earliest comparative period presented. The FASB says to use the rate inherent in the lease, however that rate is practically impossible for the tenant to determine. The FASB says if that rate is not determinable, then use the tenant s borrowing rate. Well, what borrowing rate should you use? Do you use the rate as of 2017 or 2019? In this scenario, you would use the borrowing rate as of This brings us to a very important distinction between current GAAP and the new lease accounting standards. Under current GAAP, companies would use the rate at which it could obtain the funds to purchase the entire leased asset. Under the new standards, companies would use the rate at which it could obtain funds to pay for the lease payments over the lease term. These amounts could be very different (the funds to purchase the leased asset are usually much more than the payments over the lease term, especially for real estate leases). In this example then, the interest rate used would be 6%, and the present value of the minimum lease payments would be $ 19,797,618. This is the lease liability as of January 1, At this point we want to make a VERY IMPORTANT POINT: The number calculated above (19,797,618) is based on excel. If you are recalculating this example using lease software and you get that exact number above (payments are made in advance), then we hate to tell you this, but your lease software is not entirely accurate. This is because it is assuming that there is no interest paid in the first month of the lease. It means your software is still using excel in the background to make the calculation, which is not a good thing. Why? Well the number you get should actually be slightly lower than the number above, once again because of interest paid in the first month. When added together over multiple leases, this difference could be significant. You could be adding a MUCH larger liability on your balance sheet if your software is calculating the liability this way. Obviously, LeaseQuery calculates this amount very accurately. Once again, keep this in mind as you evaluate software.

5 Step 6: Calculate the Right of Use (ROU) Asset. Per FASB s lease accounting standard, the ROU asset is the liability calculated in Step 5 above, adjusted by deferred rent and lease incentives. In this example, it is the liability of 19,797,618, less the deferred rent balance as of December 2016, less the unamortized incentive balance as of December So the formula for the ROU asset is 19,797,618 minus 1,602,141 (Deferred rent as of December 2016 See Step 3 Image) minus 1,119,098 (Unamortized Incentives as of December 2016 See Step 3 Image). This gives us a total ROU asset of 17,076,379. So if this were a journal entry, it would look like this: Dr ROU Asset 17,076,379 Dr Deferred Rent 1,602,141 Dr Lease Incentive 1,119,098 Cr Lease Liability 19,797,618 Stay ahead of the curve - check out our blog post on Key Differences Between Current GAAP and The New Lease Standard Schedule your free demo of our lease accounting software today Free Demo info@leasequery.com