The functionality of dedicated real estate lease management systems has been evolving over the past three decades, and corporations are increasingly availing themselves of these specialized systems to centralize and consolidate management of their real estate leases, so accessing the data required to transition real estate leases to the new lease accounting standards should be fairly simple, right? While these systems will certainly help, many companies are finding that the accounting for real estate assets is trickier than expected. There are three big challenges that companies with large real estate lease obligations are encountering when transitioning to the new standard.
1. Accounting for multiple assets on lease
According to the new lease accounting standards, a contract is or contains a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration. A lessee has the right to control the use of an identified asset when, throughout the period of use, it has the right to obtain substantially all of the economic benefit from using the asset, the right to direct the use of the asset, and the lessor does not have substantive rights to substitute the asset.
There is now considerable complexity around separately identifying and accounting for the many physically distinct assets that are often found on real estate leases, such as:
- Several partial or full floors of office space;
- Storage space;
- A portion of a parking garage or specific parking spaces;
- Signage; and,
- Land.
Under the existing accounting standards, there is no need to identify and account for these different assets separately. It is perfectly OK to lump the lease consideration into one payment and treat it all as a rent expense. The need to separate and manage the individual assets was generally limited to operational reasons, such as exercising expansion and contraction decisions in a timely fashion, and verifying that rent charges properly reflect the existing premises.
Under the new standards, however, individually identifying and accounting for each of these assets is required. Consider:
- Does your existing lease data properly capture the existence of each asset contained in the lease, and does your system (or spreadsheet) properly allocate the lease consideration to each asset?
- Do you have systems and processes in place to ensure that new leases will be properly abstracted to reflect the existence of multiple assets?
- Do you have processes and controls in place to manage and account for changes that take place with respect to these assets over the entire lease lifecycle?
With the valuation of these assets now being included on the balance sheet, this requirement will have far-reaching implications, not the least of which will be significant scrutiny from auditors. Thus, it’s critical for real estate managers to work closely with controllers to design and implement the policies, processes, and controls required to properly identify and account for the different assets that can be found in existing and new leases.
2. Separating lease and non-lease components
Under the new standard, lessees must be able to allocate the consideration of a lease contract to the lease and non-lease components. At a high level:
- Lease and non-lease components both transfer a good or service from the landlord to the tenant.
- A lease component specifically transfers the right to use the asset(s) on lease.
- A non-lease component transfers a good or service that is apart from the tenant’s right to use the asset.
This is particularly relevant with respect to gross leases, where the lease consideration comprises both base rent for use of the office space (the lease component) as well as common area maintenance charges, cleaning costs, utilities charges and more (the non-lease components). The consideration allocated to the lease component is incorporated into the calculation of the lease liability and right-of-use asset on the balance sheet, whereas the non-lease component is treated as an operating expense with no balance sheet impact.
The new standard provides a practical expedient (effectively, a shortcut) that permits the lessee to make an accounting policy election by asset class to not separate the non-lease components from the lease components. This is an example of when the real estate executive should work with the controllership to make the correct decision. One determining factor is the impact the decision will have on the company’s balance sheet. Since valuation of the lease liability and right-of-use asset is based on the present value of the lease payments, including the portion of the payment attributable to non-lease components (by choosing not to separate) will increase this valuation and the resultant effect on the balance sheet — an outcome that may or may not be desirable. However, selecting the practical expedient will also significantly reduce the compliance burden the company would otherwise incur if it had elected to separate.
In addition to identifying the lease and non-lease components, calculating the allocation between the lease and non-lease components must closely follow the prescribed methodology contained in the accounting standard. Without venturing too deeply into the weeds, the allocation must be based on the standalone observable prices (essentially, the market price) for each of the components. This method was written into the accounting standard to ensure that dealmakers don’t structure the lease to artificially weight the lease or non-lease component, which in turn, might artificially skew the balance sheet effect.
As with identifying multiple assets in a lease, the real estate executive and controller must collaborate to design and implement the policy, processes and control required to document the company’s identification of the lease and non-lease components, along with its policy election about whether to separate the components. They then must ensure that the election is employed consistently and accurately across the asset classes for existing leases and new leases as they are signed.
3. Capturing reassessments, modifications and remeasurements
According to the new standards, the potential real estate-specific scenarios that can occur over the lifecycle of the lease will generally fall into three categories:
- Reassessment: Reassessment is required when a situation occurs that could cause the lessee to change a previous judgement or estimate within the bounds of the contract. An example of this relates to a renewal option. Under the new standard, judgment must be employed to decide whether the company is reasonably certain to exercise an option to renew the lease. The classification of the lease, and the valuation of the right of use asset and lease liability, depends on the reasonably certain holding period, defined as the contractual term plus any renewal term that the company is reasonably certain to exercise. This determination, and the resultant classification and valuation, must occur at the lease commencement date. Any revision to this determination will require a reassessment to occur.
- Modification: Modification occurs when there is a change to the agreed upon terms of the agreement that occurs outside the bounds of the contract, effectively, a renegotiation of the existing lease. Examples of modifications might be an amendment to extend or shorten the lease term, or to add or contract the space, when no options to do any of these exist in the original document.
- Remeasurement: Remeasurement is required when a reassessment or modification results in a change to the value of the right-of-use asset and lease liability. Remember that the right-of-use asset and lease liability are a function of the lease payments and duration of the contract. Thus, any change to the term of the lease, amount of square footage, or size of the fixed payments will require the lessee to remeasure the value of the right-of-use asset and lease liability as of the effective date of the change, effectively closing the existing lease and creating a new modified lease (for accounting purposes). The mechanism for performing this calculation is detailed in the accounting standards.
The important thing to remember, however, is that the real estate executive must ensure that there are policies, processes, controls and systems in place to capture all the changes that can occur across the global lease portfolio, to ensure that the data is complete and up to date, and supports accurate accounting that’s required for ongoing, sustainable compliance.
The new lease accounting standards introduce a number of new judgments and data requirements for real estate executives to capture in their real estate systems. Compliance with the new lease accounting standard is a journey, not an event. In other words, the real estate executive and controller must gather the data, make the judgments and calculations required under the standard for all existing leases, and design and implement appropriate policies, processes, controls and systems to continue to capture data associated with new leases.
