A new lease on life: current issues in lease accounting.
SFAS 13, Accounting for Leases, released in November 1976, is the primary technical literature on lease accounting for GAAP-based financial statements. Other authoritative pronouncements on lease accounting include: SFAS 98, Accounting for Leases (May 1988); FTB 85-3, Accounting for Operating Leases with Scheduled Rent Increases (November 1985); FTB, 88-1, Issues Relating to Accounting for Leases (December 1988); and FSP 13-1, Accounting for Rental Costs Incurred during a Construction Period (October 2005). All cover operating lease accounting issues--the recognition of rent expense and the amortization of leasehold improvements.
Typical Lease: Example
Each lease is unique; however, the following example is meant to illustrate a typical lease in the chain restaurant industry. Casual Dining, Inc. (CDI), is a casual-dining restaurant chain. Attractive Properties, Inc. (API), owns shopping malls and leases space in the malls and associated parking space to tenants. Quality Builders, Inc. (QBI), is a building contractor specializing in restaurants.
API and CDI enter into an operating lease agreement for space in the parking lot of a mall owned by API. API owns the site; CDI pays rent to API. CDI hires QBI to convert the leased site into a restaurant. The base, or primary, lease term is 20 years. Additionally, the lease provides four renewal option periods of five years each, for a total of 40 years. CDI can exit the lease at any five-year interval after 20 years.
The operating lease contains escalating lease payments. During the base lease term, the monthly lease payment is $10,000 for the first 10 years and $12,000 for the next 10 years. During the first renewal option period (years 21-25), the monthly rent payment is $14,000. For each succeeding renewal option period, the rent increases in $2,000 increments. Therefore, the monthly rent payment for the final renewal option period (years 36-40) amounts to $20,000.
The chain restaurant industry has three sectors: casual dining (e.g., Applebee's, Ruby Tuesday); fast casual (e.g., Moe's Southwest Grill, Panera Bread); and fast food (e.g., Hardee's, McDonald's). Generally, casual dining restaurants will pick up some renewal options in the leases because the higher cost to build such restaurants means a longer term is necessary to realize a return. On the other hand, fast-food restaurants normally fulfill only the base term of a lease and do not invest as much in their buildings.
Because each lease is unique and different in its provisions, restaurants must evaluate lease agreements carefully. When deciding whether to build a restaurant in a certain location, the nature of the property must be considered. Restaurants in shopping malls may have a lifespan of about 20 years. If the mall deteriorates, the restaurant's profitability may decline significantly. Restaurants in malls fall in and out of favor as tenants come and go. A stand-alone restaurant (e.g., a freestanding structure with its own parking lot) may have a life of 30 to 35 years. Restaurants spend more on stand-alone units as opposed to units in malls.
A major part of the lease analysis involves the evaluation of option renewals. Lessees must consider the economic, required, and necessary returns they desire on their investments. The entity makes its decision at the front end of the lease regarding how long to keep the restaurant open. This determines the number of renewal option periods "reasonably assured" to be exercised.
GAAP has requirements for operating leases regarding the pattern of rent-expense recognition and the amortization of leasehold improvements by the lessee. The period over which the leasehold improvements are amortized should be the same period over which the rent payments are expensed. This results in a "matching" of the lives. Such can be accomplished, for example, by extending the lease term to include renewals or by shortening the amortization life of the fixed asset (leasehold improvement). The fixed-asset side and the rent-expense side must be in sync.
Leasehold improvements should be amortized by the lessee in an operating lease over the shorter of the lease term or their economic lives. Amortizing leasehold improvements over a term that includes the assumption of lease option renewals is proper only when the renewals are reasonably assured. Picking up some renewal option periods increases the straight-line rent average. With escalating lease payments, the lessee must use the average rate.
Returning to the example above, assume that CDI needs the stand-alone restaurant to stay open for 30 years (i.e., "reasonably assured," per SFAS 98). In such a case, the leasehold improvements will be amortized over 30 years and the rental payments will be expensed at the average monthly rate on a straight-line basis over the same 30 years. The monthly rent expense will be approximately $12,333 ($4,440,000 / 360).
Because "reasonably assured" is not an easy test to meet, SFAS 98 provides an explanation of the concept in paragraph 22a. Lease term is defined as follows:
The fixed noncancelable term of the lease plus (i) all periods, if any, covered by bargain renewal options, (ii) all periods, if any, for which failure to renew the lease imposes a penalty on the lessee in such amount that a renewal appears, at the inception of the lease, to be reasonably assured, (iii) all periods, if any, covered by ordinary renewal options during which a guarantee by the lessee of the lessor's debt directly or indirectly related to the leased property is expected to be in effect or a loan from the lessee to the lessor directly or indirectly related to the leased property is expected to be outstanding, (iv) all periods, if any, covered by ordinary renewal options preceding the date as of which a bargain purchase option is exercisable, and (v) all periods, if any, representing renewals or extensions of the lease at the lessor's option; however, in no case shall the lease term be assumed to extend beyond the date a bargain purchase option becomes exercisable. A lease that is cancelable (a) only upon the occurrence of some remote contingency, (b) only with the permission of the lessor, (c) only if the lessee enters into a new lease with the same lessor, or (d) only if the lessee incurs a penalty in such amount that continuation of the lease appears, at inception, reasonably assured shall be considered "noncancelable" for purposes of this definition.
A penalty is defined in paragraph 2b of SFAS 98 as follows:
[A penalty is any] requirement that is imposed or can be imposed on the lessee by the lease agreement or by factors outside the lease agreement to disburse cash, incur or assume a liability, perform services, surrender or transfer an asset or rights to an asset or otherwise forego an economic benefit, or suffer an economic detriment. Factors to consider when determining if an economic detriment may be incurred include, but are not limited to, the uniqueness of purpose or location of the property, the availability of a comparable replacement property, the relative importance or significance of the property to the continuation of the lessee's line of business or service to its customers, the existence of leasehold improvements or other assets whose value would be impaired by the lessee vacating or discontinuing use of the leased property, adverse tax consequences, and the ability or willingness of the lessee to bear the cost associated with relocation or replacement of the leased property at market rental rates or to tolerate other parties using the leased property.
In the example above, consider that CDI entered into an operating lease with API containing no renewal options. The rental payments started January 1, 2005, and continue for 15 years, or 180 months. On April 1, 2004, QBI started converting the site into a restaurant, with CDI paying the construction costs. During the construction period, no rental payments were made by CDI to API, and no rental expense was booked. The restaurant opened for business on January 1, 2005, and CDI began making rental payments and booking straight-line rent expense.
According to GAAP, rent expense should be recognized on a straight-line basis over 189 months. The total rent expense will be the same; however, the monthly average will decrease over 189 months and begin during the construction period. GAAP does not allow for the capitalization of rent expense during construction. Yet, some or all of the Big Four thought it was permissible for their clients to capitalize rent expense during construction as long as they did not have a policy in place to expense rent during construction. SFAS 34, Capitalization of Interest Cost, does allow for the capitalization of interest expense during construction. A rent holiday, however, gives rise to a rent-expense period that is longer than the amortization-expense period.
Thus, the accrual of straight-line rent expense starts when CDI has control and possession of the leased space--once CDI has permission to start building (converting the site) and cannot back out of the lease. Rent holidays in an operating lease should be recognized by the lessee on a straight-line basis over the lease term, which includes the rent-holiday period.
The Next Issue
The operating-versus-capital-lease classification game of off-balance-sheet financing was not the major lease reporting issue in 2005. It is an up-and-coming issue in lease accounting, however, that deserves attention.
Many lease agreements are crafted by the parties to avoid the capital lease requirements. This form of off-balance-sheet financing can keep a large liability off the lessee's balance sheet and improperly reflect the economic substance of the transaction. This, in turn, increases debt capacity, improves financial ratios, helps credit ratings, and lessens the risk of bond covenant violations. These synthetic lease agreements are merely efforts to structure a deal to circumvent the spirit of SFAS 13.
The SEC is pushing an international convergence of U.S. and international accounting standards, and leasing is one area getting a lot of attention. Issued in 1997, IAS 17, Leasing, is quite similar to SFAS 13. The International Accounting Standards Board (IASB) concluded that lease accounting should be reformed. When a lessee signs a lease, a liability and an asset for the lessee is almost always created. Thus, more leases probably should be capitalized.
Lease accounting, whether operating or capital, is a complex issue that has justifiably come under increased scrutiny. This author believes that lease accounting should be reformed. The topic is on FASB's agenda, and it has announced it will address the issue in concert with the IASB. This author expects FASB to issue a standard requiring any lease of more than 12 months to be categorized as a capital lease. Whatever the details, new, concept-based standards are likely coming soon, so all lessees should prepare themselves for the potentially expensive ramifications of a "new lease on life."
Andrew D. Sharp, PhD, CPA, is a professor of accounting and Caestecker Chair in the liberal arts division of business at Spring Hill College, Mobile, Ala.
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|Title Annotation:||accounting; financial statements|
|Author:||Sharp, Andrew D.|
|Publication:||The CPA Journal|
|Date:||Sep 1, 2006|
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