Lease Modifications Trigger New Headaches

Accountants are noticing an uptick in lease modifications, and they’re warning companies to be mindful of the accounting and financial reporting consequences.

Walmart provided a plain reminder in recent Form 8-K and 10-Q filings that existing accounting rules around lease accounting can be tricky, when it disclosed a material weakness in controls around lease accounting. The company said it found mistakes in its application of lease rules for the purchase of certain structural components for leased properties, most notably HVAC systems.

Accounting rules call for an analysis of when such payments indicate ownership, which would suggest such costs should be capitalized on the balance sheet, the company said. “Generally, in these situations, the company has not accounted for the total project costs of the lessor as owned assets,” Walmart wrote in its 8-K, which was filed on Aug. 18. In its more recent 10-Q, Walmart said its assessment so far reveals the adjustments will be “immaterial for all periods” and will be reflected in its third-quarter financial statements.

PwC has issued a video alert on lease modifications (without any reference to specific companies or regulatory actions) indicating that the subject will be an accounting issue for the foreseeable future as real estate is in demand. “Many companies are investing in real estate to accommodate growth or upgrade facilities,” PwC partner Chad Soars said. “It’s not uncommon for this to require a lessee to negotiate an exit of existing space, with the timing carefully planned to minimize disruption to operations and to minimize overlapping rental costs. When a lessee changes any existing lease, it can have accounting consequences.”

Growth is expected in real estate as a result of “strong market fundamentals and the availability of a diverse array of funding sources,” Bob O’Brien, U.S. real estate industry leader at Deloitte, said in a recent alert. Rents and vacancies are expected to improve across property types, he said, along with the availability of financing through traditional and non-traditional channels.

Al Ferrara, a partner in the retail practice at BDO USA, says the market is correcting as some retailers are missing sales targets. “We’re seeing companies that are getting close to the expiration point renegotiating lease terms with their landlords,” he says.

Many, he says, are looking to shed terms that set a minimum rent with percentage increases as certain sales thresholds are met. “They are negotiating to play flat out with no minimums,” he says. “The big players are able to negotiate terms closer to what the economics should be. The smaller guys don’t have as much leverage.”

“The big players are able to negotiate terms closer to what the economics should be. The smaller guys don’t have as much leverage.”
Al Ferrara, Partner, BDO USA

Dale Derks, managing director at accounting firm CBIZ MHM, says he sees clients renegotiating leases “in multiple directions.” Some companies are looking for rent reductions or less square footage, while others are looking for more space. “The most common lease modification I see is an extended term length, but at a lower price or giving up some space,” he says.

Prepare Yourself, and Your Lease

Regardless of whether a company is adding or reducing space or cost, the accounting implications can sometimes come as a surprise, experts say.

“A lot of times the individuals doing the negotiations for the real estate of a company may not be involved in accounting or finance,” says Eric Diamond, senior audit manager at accounting firm EisnerAmper. “They may be looking at the operational or legal aspect, and the deal gets finalized. Then the accounting and finance personnel go through it and realize they need to account for something differently.”

That doesn’t mean companies should structure leases to achieve a particular accounting result, Diamond says, but it’s always best to avoid surprises. “They need to be aware,” he says.

One important point to be aware of, Derks says, is whether the early exit of a leased property results in a termination penalty, even if one is not explicitly stated. “Sometimes that will get included in the restated rent amount in the new lease, but under [Generally Accepted Accounting Principles] you need to look to see if that new rent amount is in line with the market value,” he says. “If the renegotiated lease is at market, you probably don’t have a termination penalty. But if you’re paying more, you probably have an embedded termination penalty.”

WALMART LEASE REMINDER

Below is an excerpt from Walmart’s Form 10-Q in which the company discusses lease accounting rules.
As previously disclosed in the company’s Form 8-K furnished on August 18, 2015, we have been engaged in a review of the accounting treatment of leases. As part of this ongoing global review, we are assessing our historical application of Accounting Standards Codification 840, Leases, regarding lessee involvement in the construction of leased assets. While we are in the final stages of management’s assessment and review of the impact of the related errors, management believes that the maximum cumulative adjustment to the accompanying Balance Sheets, Statements of Income, and Statements of Cash Flows is immaterial for all periods. We anticipate recording the immaterial cumulative adjustment in the third quarter of fiscal 2016.
These immaterial errors resulted from the failure to appropriately consider the implications of ASC 840 with respect to lessee involvement in the construction of leased assets. In a number of our leases, payments we have made for certain structural components included in the lessor’s construction of the leased assets will result in the company being deemed the owner of the leased assets for accounting purposes. As a result, regardless of the significance of the payments, ASC 840 defines those payments as automatic indicators of ownership and requires the company to capitalize the lessor’s total project cost on the balance sheet with a corresponding financing obligation.
Generally, in these situations, the company has not historically accounted for the total project costs of the lessor as owned assets. Additionally, upon completion of the lessor’s project, the company must perform a sale-leaseback analysis pursuant to ASC 840 to determine if the company can derecognize these assets and the related financing obligation from its Balance Sheet. In a substantial number of our leases, due to many of the same factors that required the company to originally account for the total project costs as owned assets (for example, a portion of the construction costs is reimbursed to the company via lowered rental payments), we are deemed to have “continuing involvement,” which precludes the company from derecognizing these leased assets when construction is complete. In such cases, the leased assets and the related financing obligation remain on the Balance Sheet and are amortized over the lease term.
Source: Walmart.

Any termination penalty, whether explicitly stated or embedded into the new lease, must be expensed in the income statement immediately, Derks says. “So you would have a deferred liability if you are paying it down, but you would take the P&L hit up front,” he says. “Fairly or not, a tenant is supposed to understand what market values are and what GAAP says about that.”

When terminating a lease early, companies need to take stock of any assets or liabilities associated with the lease that must be resolved, such as leasehold improvements, deferred rent credits, or deferred incentives, says Scott Lehman, a partner at Crowe Horwath. Where amortization schedules are associated with such items, those schedules need to be adjusted to reflect the change in lease terms.

Companies also need to take note of when the modification of a lease causes an operating lease (which is off the balance sheet) to be classified as a capital lease (which must be brought onto it). When the fair value of a property drops or the value of a property changes as a result of leasehold improvements, that can trigger a difference in classification, Lehman says. “We are seeing cases where leases are turning into capital leases due to changes in the fair value of the property,” he says.

Even determining the beginning and end of a lease term can be tricky, PwC warned. A lease begins not necessarily on the date specified in the agreement, but on the date when control over and responsibility for the property transfers, Soars said. That analysis can get complicated if improvements are made to a leased property before a tenant actually moves in.

On the other end of things, the term includes the non-cancelable portion of the lease, plus any optional renewal periods that a company is reasonably likely to exercise, Marc Jerusalem, a director with PwC, said in the same video. The more a company has invested in a lease, the more unique the space—and the more difficult it would be to replace, the more likely the assessment would conclude that the company will probably renew the lease.

Still on the horizon, the Financial Accounting Standards Board and the International Accounting Standards Board are expected soon to finalize new standards for lease accounting that would take effect in a few years. Derks says accountants are advising companies that are renewing leases and even debt agreements today to confirm that the contract language reflects the pending change in GAAP.

“We’re recommending companies use what people are calling ‘frozen GAAP’ terms, so when GAAP changes, it doesn’t put you out of compliance with existing agreements,” he says.