New Accounting Rules May Affect Some Projects

Commercial real estate businesses and professionals may soon be impacted by new accounting regulations.

Some changes will impact revenue recognition, fair value accounting and disclosure, receivables accounting and disclosures, and goodwill testing. But the most dramatic impact will come from the new project on leasing, which will definitely have a significant impact on the commercial real estate industry.

Under the existing rules, the lessee classifies leases as either operating or capital, depending on the terms. If operating, the leasing costs are expensed as incurred and no asset or liability is recorded, future commitments are only disclosed. If capital, an asset and liability are recorded. The lessor records leasing income or a sale, depending on the terms, and typically mirrors treatment by the lessee.

The proposed new rules introduce more of a “right-of-use” model, as opposed to an ownership model. They will have implications for both the lessee and the lessor.

The lessee would record an asset and a liability. They would amortize the asset over the shorter of the expected lease term or the useful life, and record interest expense on the liability. The lessor would record an asset representing its right to receive lease payments. Depending on exposure to the risks and benefits associated with the asset, they would choose the “performance obligation approach” or the “derecognition approach.”

If the lessor retains exposure to significant risks or benefits associated with the underlying asset, they would continue to keep the asset on their books and also record a lease liability. They would record interest income on the receivable and depreciation expense on the asset. The lessor would be viewed as satisfying the lease liability continuously over the lease term, and therefore would recognize lease income continuously over the term. This is called the performance obligation approach.

If a lessor does not retain exposure to significant risks or benefits associated with the asset, accounting would be similar to that for capital leases. The lessor would derecognize the asset and record a sale. There is limited guidance on how to evaluate risks or benefits, but factors include significant contingent rentals, options to extend or terminate the lease, the duration of the term compared to the useful life of the underlying asset, and whether a significant change in the value of the asset is expected at the end of the term. Valuing the assets and liabilities in these scenarios is also complicated.

Lessees would be most affected by the changes if they have a significant portfolio of assets held under operating leases, especially those with leases of property. These rules could impact debt covenants or other agreements that limit capital improvements or incurring new debt.

Lessors will be most affected if they have long-term leases with limited exposure to risks and benefits. They will not have the asset on their books, although they will have title to it. Their financial statements will change, which may impact their ability to refinance or borrow.

The new rules received so many comments they were withdrawn for changes and will be re-exposed. Commercial real estate professionals should watch and plan for any impact the new version may have.

Alan Chosed, a CPA, is an audit partner with Kaufman Rossin

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