What is GAAP rent and how does it impact SOX ?

Lucernex expert Jim Duport (see Jim’s management summary here) provides this response:

In essence, GAAP (Generally Accepted Accounting Principals) rent is an averaging of the rent over the term taking into account rent abatement and fixed/known rent increases. The rent cost calculated based on GAAP is then charged/booked to the Income Statement / Profit & Loss (P&L) statement. The P&L statement is what is reported to the Securities and Exchange Commission (SEC) and is used for tax purposes. In many corporations, the GAAP rent is also the cost that is charged to the real estate department’s or end-user’s budget.

CPI & GAAP — a CPI GAAP analysis

What happens if there is free rent and rent increases are based on the Consumer Price Index (CPI), a “CPI GAAP analysis”? Since increases are not a “known” value, it is difficult to apply GAAP to a lease with CPI increases.

However, what happens if there is a 20 year term, the first 18 months of rent is free, and the rent increases by the CPI starting in year 11? A solution is to adjust the P&L rent for the Base Rent (i.e., the initial rent without any increases) and straight line that cost to the P&L. The CPI increases can then be added as a separate line item starting in year 11. For analysis purposes, we call this a CPI GAAP analysis.

What are some other GAAP requirements?

The estimated costs for Restoration, also known as Make-Good and Dilapidations in the UK, need to be charged to the P&L. The cost is estimated and then amortized over the term.

Landlord inducements, including a landlord’s construction allowance, needs to be accounted for differently. The logic is the inducement is a loan from the landlord and included in the base rent. Consequently, GAAP requires the tenant capitalize the cost without the landlord allowance deduction and depreciate this total cost. The landlord’s allowance is treated as a credit to capital cost in terms of Cash Flow and on the P&L it is treated as a net rent credit spread over the balance of the term. In the event there is another inducement besides a construction allowance at a later date in the term, that cost is again treated as a credit to net rent over the remaining balance of the term.

LX LseMod Corporate includes the OPTION to treat all or part of these requirements using, or not using GAAP.

Are Subleases impacted by SOX?

GAAP also dictates how the costs associated with subleases need to be calculated to be in compliance with SOX. Start by determining the net present value of all rental costs including write-offs of depreciation and subleasing costs, offset by the sublease income, the NPV (net present value) write-off. The Income Statement (Profit & Loss statement) is then charged the NPV write-off and it is charged an interest expense based on a declining balance of the NPV write-off, the accretion interest expense. The declining balance is determined by taking the net monthly costs (including sublease income) and the interest expense and deducting that cost from the NPV write-off.

Capital vs. Operating Leases

Four tests required to determine if a lease is a Capital instead of an Operating Lease are as follows:
Test 1 – Does Title Revert to Tenant
Test 2 – Is there a Bargain Purchase Option
Test 3 – Is the lease greater than 75% of Remaining Life of the building
Test 4 – Is the Present Value of Rent greater than 90% of the Fair Market Value of the building?
Lx LseMod Corporate includes these four tests.

How do Lucernex applications help with SOX rent compliance?

Because Lx LseMod Corporate does rent analysis on a GAAP basis, it can be part of a solution that will meet the requirements of Sarbanes Oxley. Additionally, users can evaluate different scenarios that may happen partially through a lease term by adjusting the rent to a predetermined GAAP value. Note: Lx LseMod has developed a number of software solution for real estate financial analysis and also has applications that evaluate leases based on just Cash Flow and do not include the corporate P&L (the part requiring GAAP) and taxes.

See a Sample Financial Report handling GAAP for SOX compliance.

See a Sample P&L Impact Report handling GAAP for SOX compliance.

In Q1 2010, Lx LseMod Corporate will be integrated into the Lx IWMS in our Lease Adminsitration and Rent Accounting solution (Lx Contracts). This solution will enable users to utilize the time tested Lx LseMod Corporate financial engine within the Lx IWMS to perform GAAP rent analysis and all other analyses in the solution, and instantly include them in site selection and lease renewal decision processes.

Other Lx LseMod features that support GAAP compliance:

• Straight-line rents
• Rent accrual during construction
• TI credit to rent
• Over-ride GAAP rent for scenario analysis
• Other rents, e.g. satellite dish, based on GAAP
• Restoration accrual (FASB 143)
• Restoration carry-over
• Sublease analysis based on GAAP
• Ability to add costs later in term (mid-term construction) and account for LL TI$

Jim’s Next Blog –> GAAP in Commercial Real Estate Sublease Accounting

Tags: Commercial real estate analysis, commercial real estate software, CPI GAAP Analysis, GAAP, GAAP Accounting, GAAP impact on SOX, GAAP rent, lease accounting blog, Lease Administration software, SOX