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Increased clarity in accounting for operating leases: industry practices meet GAAP.

In a February 7, 2005, SEC staff letter to the AICPA's Center for Public Company Audit Firms (CPCAF), then-SEC Chief Accountant Donald Nicolaisen provided clarity on the application of three key issues for lessees:

* The proper amortization period for leasehold improvements;

* Accounting for rent holidays; and

* The treatment of construction incentives received from landlords.

The resulting wave of restatements highlighted the diversity in long-standing industry practices and the misapplication of existing GAAP in these areas. Management at many companies was apparently caught off guard by the SEC's positions. When announcing restatements, companies often referred to prior industry accounting practices that they believed to be acceptable; many stressed the "non-cash impact" of their restatements. Others reminded investors of the "clean" opinions received from their external auditors (predominantly Big Four firms) during the years in which these accounting practices were in place. Although the restatements were concentrated in the retail and restaurant industries due to the considerable number of real estate leases typical in these businesses, certain underlying issues apply to all operating lease arrangements.

Issue 1: Amortization of Leasehold Improvements

Leasehold improvements placed in service (or contemplated) at or near the beginning of the lease term are generally amortized on a straight-line basis over the shorter of the estimated useful life of the assets or the lease term. Determining the lease term for this purpose often requires judgment to ascertain whether to include periods covered by renewal options. Paragraph 22(a) of SFAS 98, Accounting for Leases, defines the lease term as the fixed noncancelable term plus periods covered by renewals or extensions, depending upon the facts and circumstances surrounding the agreement. [SFAS 98 amended the definition of "lease term" in paragraph 5(f) of SFAS 13, Accounting for Leases, November 1976, particularly with respect to: 1) the treatment of renewal periods where the lessee has provided a loan to the lessor, and 2) the definition of "penalty."] In general, option periods are included in those cases where, at the inception of the lease, a renewal appears to be "reasonably assured." In arriving at this conclusion, management must carefully evaluate whether a failure to renew the lease imposes a significant "penalty" on the lessee such that renewal is deemed to be reasonably assured. Exhibit 1 contains a detailed discussion of criteria that practitioners must use to evaluate the lease term and factors to consider when assessing the impact of direct or indirect penalty provisions.


The theoretical and practical considerations concerning the amortization of leaseholds are well documented in the accounting literature. Essentially, the SEC staff reaffirmed existing GAAP, particularly with respect to treatment of renewal periods. Many restatements have resulted from cases where companies amortized leasehold improvements over extended terms that included available renewal options, whether exercise was reasonably assured or not. Accordingly, the extended terms lowered the amortization expense recognized and overstated net income. Exhibit 2 illustrates the considerations and proper amortization period for leasehold improvements, as well as the financial statement impact of common errors.

As a follow-up, FASB Emerging Issues Task Force (EITF) Issue 05-6, Determining the Amortization Period for Leasehold Improvements Purchased after Lease Inception or Acquired in a Business Combination, was issued to address the amortization of leasehold improvements acquired "significantly after and not contemplated at or near the beginning of the initial lease term" or assumed in a business combination. These "subsequently acquired" leasehold improvements should be amortized over the shorter of their estimated useful life or the remaining lease term (reflecting renewal periods that are reasonably assured at the time of purchase or acquisition). EITF Issue 05-6 is applicable to improvements acquired in periods beginning after June 29, 2005. It does not, however, apply to preexisting leasehold improvements, and it may not be used as a basis to reevaluate the amortization periods of those assets.

Issue 2: Accounting for Rent Expense under Operating Leases

It is common for a landlord to provide a tenant with a rent-free period (or holiday) at the initial portion of the lease term. Such provisions are viewed as incentives for the lessee to sign the lease and typically range in length from a few months to one year. Rent holidays permit the lessee to have access to the property to complete the build-out or preparation of the structure while alleviating the burden of rent payments during this timeframe. Other lease arrangements could provide for lower rent payments during the early portions of the lease or contain scheduled increases to account for expected inflation.

FASB Technical Bulletin (FTB) 85-3, Accounting for Operating Leases with Scheduled Rent Increases, in conjunction with the response to Question 1 of FTB 88-1, Issues Relating to Accounting for Leases, stipulate that rent expense for operating leases with rent-free periods or scheduled increases must be accounted for on a straight-line basis over the lease term, including the related holiday period, unless another systematic and rational method is more representative of the lessee's pattern of use over time. This treatment assumes that the lessee takes possession of or controls the property at the inception of the lease. The SEC staff letter reaffirmed existing GAAP and emphasized the inclusion of the rent holiday within the lease term.

A large number of the restatements during 2005 were driven by prior practices where companies neglected to accrue rent expense during the period of the rent holiday. For instance, Ruby Tuesday, Inc., reported in a press release (April 11, 2005) that its restatement was due in part to the "computation of straight line rent at the earlier of the commencement of the lease payments or when the leased site opened." Similarly, Ann Taylor Stores Corporation reported (March 17, 2005) that it "had previously recorded straight-line rent expense beginning on the store opening date, as the Company believed that 'possession' under FTB No. 88-1 occurred on the date it took physical control of the space through occupancy, without considering the construction build-out period." In such cases, corrections would serve to increase rent expense recognized during prior rent holidays and decrease rent expense recognized during subsequent periods of the lease.

Consistency is essential when using the lease term in related facets of lease accounting. More specifically, a lessee should use the same lease term to determine: 1) the proper classification as either a capital or operating lease, 2) the appropriate period for amortizing leaseholds, and 3) the proper term over which to recognize straight-line rent. Many restatements revealed inconsistent treatment, whereby the company used a longer lease term (including renewals) to amortize leasehold improvements but used the shorter initial term to recognize rent expense.

Issue 3: Accounting by Lessees for Incentives Received in an Operating Lease

A landlord may provide a tenant with an incentive to sign a particular lease arrangement. Incentives can include a direct cash payment, payment of expenses on behalf of the lessee (e.g., moving expenses), or a reimbursement of costs related to leasehold improvements. Question 2 of FTB 88-1 and paragraph 15 of SFAS 13 require that a payment made by a landlord to or on behalf of a lessee represents an incentive that must be reported by the lessee as a liability (deferred rent) and as a reduction in rent expense on a straight-line basis over the lease term. This treatment considers the incentive to be an inseparable element of the overall agreement that should be recognized along with the other lease provisions.

Diversity in practice had developed with respect to the accounting by lessees for construction-related incentives. When announcing restatements, many companies disclosed their previous practice of netting the cash received against the cost of the associated leasehold improvements rather than accounting for the reimbursements as deferred rent. This treatment understated amortization expense and overstated rent expense recognized over the term of the lease. On the statement of cash flows, this practice understated both the net cash outflows from investing activities and net cash inflows from operating activities.

For example, Payless Shoesource, Inc., reported (March 1, 2005) that a portion of its restatement was due to the "practice of netting landlord-provided tenant improvement allowances against [the related] property and equipment" and did not impact earnings. McCormick & Schmick's Seafood Restaurants, Inc. reported (March 28, 2005) a similar correction, adding that the restatement increased the balances of leasehold improvements and deferred rent liabilities on the balance sheet and that it increased amortization expense and decreased rent expense on the income statement.

In its February 7, 2005, letter, the SEC staff reaffirmed the appropriate accounting treatment for landlord incentives under FTB 88-1, specifically stating that "it is inappropriate to net the deferred rent against the leasehold improvements." On the statement of cash flows, purchases of leasehold improvements and the amount of the incentive received should be reported "gross" within investing activities and operating activities, respectively. Exhibit 3 illustrates the appropriate accounting by lessees for incentives received from a landlord and the financial statement impact of errors common in practice.

Rental Costs Incurred During Construction

The restatements led to further scrutiny of existing practices pertaining to lessee accounting for ground (land) leases and rental costs incurred during building construction. Diverse accounting practices, coupled with a perceived lack of specific guidance in this area, were analyzed in EITF Issue 05-3, Accounting for Rental Costs Incurred during the Construction Period. Essentially, the EITF examined the long-standing debate:

* Do these rental costs qualify for capitalization?

* If so, is capitalization appropriate for ground rentals, building rentals, or both during construction?

Exhibit 4 provides an expanded discussion of the different views on this issue.

The EITF was unable to reach a consensus on the views discussed in Issue 05-3. In October 2005, however, FASB issued formal guidance in FASB Staff Position (FSP) FAS 13-1, Accounting for Rental Costs Incurred during a Construction Period. This FSP concluded that rental costs are incurred for the right to control the use of leased property, and that there is no distinction between the right to use leased property during or after construction. Accordingly, the staff concluded that a lessee may not capitalize rental costs associated with either ground or building operating leases that are incurred during construction. Such costs are expensed currently and are included when determining income from continuing operations. This guidance was applicable to the first reporting period beginning after December 15,2005, at which point companies would cease rent capitalization for operating leases entered into prior to the effective date of the guidance. Retrospective application in accordance with FASB 154, Accounting Changes and Error Corrections, was permitted but not required. The latter option likely avoided further restatements by many lessees.

Landlord-Funded Improvements: Who Owns the Asset?

FTB 88-1 presumes that leasehold improvements made by a lessee but funded by the landlord (lessor) are incentives and should be recognized as assets by the lessee with a corresponding liability. In its staff letter, the SEC acknowledged that the decision to record the improvements as assets of the lessor or the lessee "may require significant judgment," but it did not introduce specific criteria. Accordingly, the lack of guidance with respect to these accounting practices has resulted in identical leasehold improvements being recorded as assets by both the lessor and lessee. Whether the assets are recorded by the lessor or lessee (or both) has a number of consequences on the financial information reported by both parties. Exhibit 5 provides an expanded discussion of these issues and related implications.

Enhanced Disclosures

The SEC staff also reminded registrants that clarity is essential when disclosing capital and operating lease information in the Management's Discussion and Analysis (MD & A) and footnotes to the financial statements. Disclosures should address the following issues:

* Material lease agreements or arrangements;

* Major provisions, such as the original lease term, renewal options, rent holidays and escalations, and incentives;

* Accounting policies for leases, including those related to the major provisions above;

* Specifics as to the determination of contingent rentals; and

* Periods used to amortize both initial and subsequently acquired leasehold improvements and their relationship to the initial lease term.


Despite the level of detailed accounting guidance developed over the last 30 years, the interpretation and application of lease accounting remains controversial. This unexpected surge of restatements in the wake of recent SEC guidance highlights the importance that all accountants refresh their understanding of these issues and undertake a review of their accounting policies and practices for leases. It also reinforces the need to regularly review the propriety and application of both new and long-standing accounting practices. Finally, it serves as a sobering reminder of the unintended consequences that can arise when existing accounting policies are deemed appropriate on the basis of "accepted industry practice."

CPAs should expect further changes and added complexity in the future. Lease accounting and other off-balance sheet arrangements remain high on the agendas of the SEC, FASB, and the International Accounting Standards Board (IASB).

James M. Fornaro, DPS, CMA, CPA, is director of graduate business programs, and Rita J. Buttermilch, CPA, is an associate professor, both at the school of business of the State University of New York-College at Old Westbury, in Old Westbury, N.Y.

EXHIBIT 1 The Lease Term

Paragraph 22(a) of SFAS 98 amended SFAS 13 by clarifying the factors to consider in establishing the proper lease term, particularly with respect to penalty provisions. Essentially, the lease term includes the fixed noncancelable term plus--

* periods covered by bargain renewal options;

* periods where the lessee's failure to renew the lease imposes a penalty (as defined) of such magnitude that, at the inception of the lease, renewal appears to be reasonably assured;

* ordinary renewal periods where the lessee is expected to guarantee the debt or provide a loan to the lessor that is directly or indirectly related to the leased property;

* renewal or extension periods that are at the option of the lessor; and

* periods covered by ordinary renewal options preceding the date in which a bargain purchase option can be exercised.

Judgment is required in evaluating whether a penalty is substantive enough to reasonably assure renewal by the lessee. Considerations include whether the lessee will pay cash (or transfer another asset or rights), incur a liability, perform services, or suffer an "economic detriment" upon failure to renew. Factors to consider when assessing whether a lessee will suffer an economic detriment include the unique nature or location of the property, the availability of replacement property, the importance of the property to the lessee's business, and the likely impairment in value of leasehold improvements upon termination of the lease.

EXHIBIT 2 Illustration: Amortization of Leasehold Improvements

On September 1, 2005, Seaford Corporation (lessee) signed a lease agreement with Aker Properties, Inc. (lessor) for office space to serve as its headquarters. The lease has an initial noncancelable term of 10 years beginning January 1, 2006, and provides Seaford with one renewal option for an additional five years. The property is in a desirable location where the market for equivalent space is tight. If exercised, the renewal option requires a "market-rate" adjustment to the rent payments. There is no cash penalty, however, if Seaford does not exercise the option. At no time does Seaford expect to extend a loan or guarantee debt of Aker that is directly or indirectly related to this property. Seaford invests $3 million during the remainder of 2005 for leasehold improvements in order to upgrade the space to be suitable for its needs. The improvements have an estimated useful life of 25 years. Seaford occupied the new space on January 3, 2006, and commenced operations.

Proper Accounting Treatment

Seaford should amortize the leasehold improvements over the shorter of the estimated useful life of the assets (25 years) or the lease term. As discussed in Exhibit 1, judgment is required in determining whether the five-year renewal period should be added to the initial 10-year term. Though it faces no cash penalty, Seaford must evaluate whether it would suffer an "economic detriment" upon termination at the end of the initial term.

Based upon a full review of the facts and circumstances, Seaford concluded that the lack of alternative space in the market, coupled with the abandoned leaseholds, would constitute a penalty such that, at the inception of the lease, renewal is reasonably assured. Accordingly, the lease term would be 15 years and would represent the period over which the leasehold improvements should be amortized. Seaford would recognize annual amortization expense of $200,000 per year ($3 million divided by 15 years).

Past Accounting Errors

Using the above facts, assume that the original lease contained a second five-year renewal option that was not reasonably assured of being exercised. Also assume that Seaford incorrectly used a lease term of 20 years (10-year initial term plus both five-year options) to amortize the leasehold improvements. Accordingly, amortization expense of $150,000 ($3 million divided by 20 years) for 2006 would be understated by $50,000. If Seaford discovered this error in 2007, the restatement of 2006 results (pretax) would be as follows:
Summary Financial Impact: 2006

                         As Originally  Adjustment
                         Reported       Dr. (Cr.)         As Restated

Balance Sheet
Leasehold improvements   $3,000,000           $0          $3,000,000
Less: accumulated         ($150,000)    ($50,000)          ($200,000)
  amortization           $2,850,000     ($50,000)         $2,800,000

Income Statement
Amortization expense       $150,000      $50,000            $200,000

Statement of Cash Flows                 Inflow (Outflow)

Net cash flow from               $0           $0                  $0
  operating activities*

*Note: The restatement has no net effect on the statement of cash flows
due to the noncash nature of the adjustment.

EXHIBIT 3 Illustration: Accounting for Incentives Received from a Landlord

On January 1, 2006, Regent Corporation (lessee) signed a 10-year operating lease for office space owned by Barker Development, Inc. (lessor). The lease requires fixed monthly rent payments of $20,000 throughout the term and does not include a renewal option or rent holiday. Regent expects to make significant improvements to the space to satisfy its business needs. As an incentive to sign the lease, Barker agrees to reimburse Regent for 25% of the first $1 million of improvements. During the six-month period from January 1 through June 30, 2006, Regent makes $1,500,000 of improvements and receives the $250,000 cash reimbursement from Barker. The improvements have an estimated useful life of 15 years. Regent occupies the new space on July 1, 2006, and commences operations.

Proper Accounting Treatment

Per FTB 88-1 and the SEC staff, Regent would account for the $250,000 incentive as a credit to deferred rent. The credit would be amortized on a straight-line basis over the lease term as an annual reduction in rent expense of $25,000 ($250,000 / 10 years). For 2006, net rent expense would be $215,000 ($240,000 paid--$25,000). Leasehold improvements would be reported at the total cost of $1,500,000 and amortized as $150,000 per year over the lease term of 10 years. For the six months of 2006, amortization expense would be $75,000. Regent's statement of cash flows would include expenditures of $1,500,000 in investing activities. Cash flows from operations would reflect rent paid of $240,000 and the $250,000 incentive from the landlord (net inflow of $10,000).

Past Accounting Errors

Using the above facts, assume that Regent incorrectly netted the $250,000 incentive against the cost of the leasehold improvements. Accordingly, amortization expense of $62,500 for 2006 ($1,250,000 / 10 years x 6/12) would be understated by $12,500 ($75,000-$62,500). Similarly, rent expense would be overstated by $25,000, representing the required annual decrease in deferred rent ($250,000 / 10 years) from the incentive. If Regent discovered this error in 2007, the pertinent financial statement effects (pretax) resulting from the restatement of 2006 results would be as follows:
Summary Financial Impact: 2006

                         As Originally  Adjustment
                         Reported       Dr. (Cr.)         As Restated

Balance Sheet
Leasehold improvements    $1,250,000     $250,000          $1,500,000
Less: accumulated           ($62,500)    ($12,500)           ($75,000)
  amortization            $1,187,500     $237,500          $1,425,000
Deferred rent liability           $0    ($225,000)*         ($225,000)

Income Statement
Rent expense                $240,000     ($25,000)           $215,000
Amortization expense         $62,500      $12,500             $75,000

Statement of Cash Flows                 Inflow (Outflow)

Net cash flow from         ($240,000)    $250,000             $10,000
  operating activities
Net cash flow from       ($1,250,000)   ($250,000)        ($1,500,000)
  investing activities

*Represents the incentive ($250,000) less the $25,000 reduction in rent
expense for 2006.

EXHIBIT 4 Should Lessees Capitalize Rental Costs Incurred During Construction?

In practice, some lessees capitalized ground or building rentals incurred during construction as part of the historical cost of a building or leasehold improvements. By analogy to SFAS 34, Capitalization of Interest Cost, they viewed the treatment of rental costs incurred during construction as equivalent to the treatment of interest costs during the same timeframe; that is, as an integral cost of readying the asset for its intended use. Others analogized to SFAS 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects, which requires real estate developers to capitalize property taxes, insurance, and other directly associated expenditures as project costs during the construction period.

Companies undertaking their own construction projects often extended this treatment to ground leases, even though the scope of SFAS 67 specifically excludes real estate developed by a company for its own use. Many lessees further extended this analogy to support the capitalization of building rentals. EITF Issue 05-3 also discussed other areas of the accounting literature that were used by lessees to support the capitalization of rental costs during construction.

Conversely, many lessees expensed rental costs incurred during the asset's construction based on the view that rent is incurred for the right to use (or control) an asset for a designated period of time. This view ignores any distinction between an asset undergoing construction activities and an asset in active use. Accordingly, these costs are not considered "probable future benefits" that qualify for capitalization. This viewpoint conflicts with the previous analogy to SFAS 34, because rental costs incurred during construction, unlike interest costs, are not deemed to be avoidable because the lessee does not generally own the underlying leased property.

In Issue 05-3, the EITF also discussed other divergent views, including whether capitalization should be limited solely to rental costs of ground operating leases. On these issues, the EITF was unable to reach a consensus. Subsequently, FASB provided formal guidance in FSP FAS 13-1.

EXHIBIT 5 Landlord-Funded Improvements: Who Owns the Asset?

In many situations, the language in the lease contract is unclear concerning the "owner" of the landlord-funded improvements. In May 2005, the EITF Agenda Committee discussed certain ramifications of this unresolved ownership issue and put forth a possible solution. The committee identified 13 qualitative factors that might be considered by the lessor and lessee in determining which party owns the leasehold improvements and therefore should recognize them for financial statement purposes. These factors included examining the obligations of the parties, remedies in the event of default, the tenant's responsibility if the improvements are altered or removed, the uniqueness of the improvements, the party liable for property taxes, and other legal and economic issues. Due to the complexities and subjectivity involved, the EITF Agenda Committee decided not to tackle this ownership issue.

The lack of formal guidance and the divergence in accounting practice has associated implications on financial reporting by lessors and lessees. Two of these are as follows:

Financial statement recognition and classification. If the improvements funded by the lessor are deemed to be owned and recognized as assets by the lessee, the lessee would also recognize the associated amortization expense and annual reductions in rent expense on its income statement using the methodology illustrated in Exhibit 3. The lessee's statement of cash flows would reflect the acquisition of the leasehold improvements in investing activities and the incentive received in operating activities. On the lessor's balance sheet, the payments should be recognized as an incentive and amortized as a reduction in annual rental income over the lease term. The incentive paid would be reported in operating activities on the lessor's statement of cash flows.

If, however, based on an evaluation of the facts and circumstances, the landlord-funded improvements are deemed to be owned by the lessor, the lessee would treat the cash received from the lessor as a reimbursement of costs on its balance sheet--not as an incentive. Accordingly, the underlying leasehold improvements, the liability for the incentive, the related annual amortization expense, and the reduction in rent expense would not be reported on the lessee's financial statements. The associated cash transactions would be reported by the lessee in operating activities on the statement of cash flows. The lessor would record and depreciate the tangible assets over their estimated useful lives and report the expenditures in investing activities on the statement of cash flows.

Lease commencement date: Does the lessee "control" the improvements? Another implication of this unresolved ownership issue pertains to whether the lessee should recognize rent expense during the construction period. As discussed previously, the recognition of rent expense begins at the point in which the lessee obtains possession of or controls the property. If the lessee owns the landlord-funded leasehold improvements, the case for control is established. Accordingly, straight-line recognition of rent expense by the lessee and rental revenue by the lessor should begin when the lessee has access to the leased property to begin constructing the improvements. If the lessor is deemed to be the owner, however, and the improvements are considered property subject to the lease, the presumption of control by the lessee during construction is not clearly established. Accordingly, recognition of rent expense by the lessee and rental income by the lessor should begin when the improvements are substantially complete.
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Title Annotation:American Institute of Certified Public Accountants' accounting standards
Author:Fornaro, James M.; Buttermilch, Rita J.
Publication:The CPA Journal
Geographic Code:1USA
Date:Dec 1, 2006
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