What Is Lease Accounting?
Lease accounting is the accounting process for recording the financial impacts of an organization’s leasing activities in their accounting calculations and reports.
Beginning in December of 2018 (effective December 2020 for private companies) the FASB issued new lease accounting standards, updating how companies are required to account for operating leases on their balance sheets. Previously companies capitalized their financing leases only, while simply disclosing their operating operating leases in the footnotes. Under the new rules, right-of-use assets and lease liabilities for all operating leases longer than 1-year are recorded on the balance sheet.
Comparing Operating Lease vs. Finance Lease
An “operating lease” is a right-to-use lease for an asset, without transferring ownership rights. A “finance lease” (formerly referred to as a “capital lease”) are all other types of leases. They are similar to operating leases but their terms transfer more rights so they are closer to ownership. A finance lease meets one of five qualifications: the title transfers at its end; the lessee has a purchase option that is reasonably certain to be exercised; the term of the lease is more than 75% of the useful life of the asset; the present value of the lease payments are more than 90% of the fair market value of the asset; or the leased asset is specific enough to the lessee that the lessor (owner) has no way to transfer it to another lessee.
What Are Lease-Option Purchases?
A lease-option purchase is a contract that gives the lessee (renter) an option to purchase the asset during or at the end of the lease term. When a lease-option is in place, the owner of the asset is barred from selling it to anyone else. At the end of a lease-option contract term, the lessee must either exercise their right to purchase the asset or forfeit it.
When Real Estate Leasing Options Make Sense for Buyer and Seller
Leasing provides an opportunity for the owner of the asset to collect income on it without forfeiting ownership, and gives the tenants more flexibility with their payments than purchasing while shouldering less responsibility than ownership. This can be especially beneficial in a high-property value area, where significant down-payment requirements or difficulty in qualifying for financing can be challenges for individuals or businesses. Similarly, if the asset’s owner is no longer using it but wishes to continue collecting income on it or finds it is not a good market to sell, leasing it out can be a viable short- or long-term solution.
Lease Accounting Topics
None at this time.
What is the fundamental issue with lease accounting regulations?
In February 2016, the Financial Accounting Standards Board (FASB) released its long awaited updated lease accounting standards. The Accounting Standards Update (ASU) on leases will take effect for public companies for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. For all other organizations, the ASU on leases will take effect for fiscal years beginning after December 15, 2019, and for interim periods within fiscal years beginning after December 15, 2020.
Under the new standard, companies are required to use a “right-of-use” accounting model where both lessees (renters) and lessors (property owners) recognize assets and liabilities arising from lease contracts. The FASB believes these changes will improve transparency as well as provide investors with more consistent and concise financial reporting.
In addition, FASB and the U.S. Securities and Exchange Commission (SEC) are working on implementing the Current Expected Credit Losses (CECL) accounting standard, which focuses on estimating expected losses over the life of a loan, using historical data, current conditions, and reasonable forecasts. The CECL standard will go into effect in January 2020 for some lending institutions. The standard currently in use relies on incurred losses.
I am a real estate professional. How do lease accounting regulations affect my business?
The new lease accounting standard may harm some businesses, especially lessees and lessors of commercial real estate. With leases included on balance sheets, some companies may see their debt-to-equity ratios increase and find it more difficult to obtain credit. The new standard may also complicate compliance with debt covenants or agreements between the bank and borrower. By capitalizing new and/or existing leases, some businesses could show more debt than allowed in their agreement with the lender, and therefore be in default of their loan. This could force some firms to put up more capital for existing loans or even have their credit lines revoked.
Additionally, the elimination of off-balance-sheet financing could be detrimental to commercial property owners. More frugal lessees will want less space and shorter-term leases without renewal options or contingent rents, which will decrease cash flow for property owners. Shorter-term rents will likely reduce the borrowing capacity of many commercial real estate lessors, who rely on leases and the value of the property as collateral in order to obtain financing. Ultimately, property owners would be forced to increase rent rates due to market uncertainty and reduce tenant improvements due to shorter recovery periods. Conversely, this change could encourage some firms to consider buying instead of leasing commercial real estate.
The CECL standards may have the effect of requiring that banks hold more capital as "counter cyclical reserves," which may impact their ability to lend - especially smaller lending institutions.
NAR Policy on Lease Accounting
NAR believes the new lease accounting standard will be detrimental to our nation’s economy. Also, NAR is opposed to lease accounting standards changes that would treat the income producing real estate business as a financing business on company balance sheets. NAR supported proposals that would have exempted privately held companies from complying with the new standard.
The new lease accounting proposal reduces the overall borrowing capacity of many commercial real estate lessees and lessors, by requiring them to recognize leases on their balance sheets as liabilities and assets, as opposed to their current treatment as operating expenses, which are not reflected on balance sheets. Including leases on balance sheets may have the effect of “bloating” them, and some companies may see their debt-to-equity ratios increase as a result, making it more difficult for them to get credit. Treating income producing real estate business as a financing business on company balance sheets will not accurately depict the unique characteristics of the investment real estate sector and in turn discounts the usefulness of the industry’s financial statements.
Legislative/Regulatory Status/Outlook on Lease Accounting
FASB released the new standard in late February 2016. The Accounting Standards Update (ASU) on leases will take effect for public companies for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. For all other organizations, the ASU on leases will take effect for fiscal years beginning after December 15, 2019, and for interim periods within fiscal years beginning after December 15, 2020.
Though the new standards are not effective for all companies yet, many companies have already begun to implement them in order to be in full compliance by the required deadlines.
The CECL standards are set to go into effect in January 2020. NAR has joined in industry coalitions and is working with Congress to extend the implementation deadline, in order to get more data on the impact of the changes on lending institutions and capital availability.
Commercial Federal Policy Committee