GAAP Sublease Accounting

Summary of GAAP/FASB Accounting for a Loss Associated with a Sublease

Our interpretation of GAAP sublease analysis according to FASB accounting rules is as follows:
Overview: 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 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.

Steps are as follows:

1. Determine a start date for the sublease analysis, e.g. if the space is vacated in January 2004 and put on the market for sublease, then the analysis starts January 2004.
2. Determine the remaining lease obligation for the balance of the term from the start date above (rent, operating expenses, taxes, i.e. what was committed to when the lease was executed).
3. Determine the net book value (NBV) of any assets that will be written off as of the start date above, e.g. un-depreciated leasehold improvements.
4. Make sublease assumptions including

• Timing, when space will be subleased
• Rent and Free Rent
• Operating Expenses and Taxes (Subtenant’s base year?)
• Commissions
• Tenant Improvement costs paid by the Sublessor associated with the sublease
• Other costs associated with the sublease

5. Calculate the total cost of the space, include the write-off of the assets on the start date and any Commissions and Tenant Improvement costs paid by the Sublessor
6. Calculate the total income from the sublease, i.e. rent and any operating expense reimbursement.
7. Determine the Shortfall that is the difference between the cost of the space and income.
8. Determine the present value of the Shortfall using a risk-free discount rate (the NPV write-off).
Note 1: The discount rate may not be the same rate as the corporation uses for internal analysis.
Note 2: Lx LseMod calculates the present value monthly based on a beginning of month payment.
9. Determine the Beginning Balance for calculation of Accretion Interest Expense. The Beginning Balance is the Present Value minus the Cash Shortfall in the current month.
10. Determine the monthly Accretion Interest Expense. This expense is the Interest on the Beginning Balance in step 9 above. The Interest rate is the same as used for the present value calculation in step 8.
11. Re-set the Beginning Balance for the next month by taking the previous month’s balance and reducing it by the Cash Shortfall in the current month.
12. Continue this process until the balance is 0.
13. At the end, all costs net out to 0 on the Income Statement (P&L).

Costs booked against the Income Statement include the following:

a. NPV Write-Off including Depreciation
b. Accretion (Interest Expense)
The net effect of GAAP subleasing is what we used to call “funny money” accounting. However, it does impact the Income Statement (P&L), which in turn impacts taxes, which impacts the After Tax NPV.

Examples See a report example to the right or view a detailed example. You can also view many other financial analysis report examples of Sublease and Lx LseMod Lease Analysis reporting.

Sublease GAAP Monthly Report

Notes

A: If the original lease costs booked to the Income Statement (Profit & Loss statement) were based on GAAP accounting (i.e. the rent was spread evenly over the term), then the calculations of the loss must be based on the GAAP rent, not the Cash Flow rent.
B: Lx LseMod Corporate Lease Analysis includes the option to create a GAAP rent analysis as well as a GAAP sublease analysis.

Disclaimer – The summary above represents our interpretation. It is NOT intended to replace information received from tax accounting professionals.

To see the actual FASB write-up, go to http://www.fasb.org/st/
scroll down the page to Statement No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.”

Intended for Corporate Real Estate Managers and Tenant Rep Brokers.

Importance of P&L?

First and foremost, in a corporation the cost charged to a manager’s budget is the PreTax P&L, not the Cash Flow. Since performance evaluations and bonuses are based on budgets, it is important to know how the impact of an action (e.g. leasing space) impacts the budget.

Profit & Loss (P&L) is what companies use when reporting financial results. A company’s P&L is perhaps more important than its Cash Flow. It shows whether or not a business has achieved its primary objective – earning a profit.

You have probably heard people say, “Profitability is key.” Profitability is different from Cash Flow. Profitability is the number reported to Wall Street and quoted in newspapers in earnings per share (EPS).

Cash Flow represents the cash coming in (sales/revenues collected) less money actually spent (salaries, rent, costs of doing business, paying off money borrowed, etc.).

A company can be profitable, but have a negative cash flow. Alternatively, a company may be losing money on paper, yet have a positive cash flow.

Although it is rare, large real estate transactions can impact a company’s profitability, and what they have reported to Wall Street analysts, and ultimately, the stock price.

A company’s key financial metric can vary over time and in any particular fiscal year. The key metric can range from the Net Present Value of the AfterTax Cash Flow, to how much Capital is required in that year, to what is the PreTax P&L impact in the current fiscal year.

Corporate managers are measured (and bonused) based on their P&L performance. Typically this measurement does not include taxes, since corporations actually keep another set of books for paying taxes, thus the real measurement is the Pretax P&L. It is important for a corporate real estate manager or an operating business unit manager to be sure the costs for an action being proposed or taken is within their budget, and their budget is a Pretax P&L, not a Cash Flow.

P&L vs. Cash Flow

In accounting for rent on a P&L basis, companies have three choices – Cash Flow, Effective Rent, and GAAP Rent. Cash Flow rent uses whatever the actual cash paid for rent to generate the rent costs on the P&L.

Effective rent takes the Base Rent and any rent abatement input (free rent), determines the average rent and uses that to generate the base rent costs on the P&L. Rent increases are added to the effective rent to generate the rent shown on the P&L.

GAAP rent takes the Base Rent, rent abatement and any increases (or decreases) and then determines the average rent and uses that number to generate the rent on the P&L. The increases must be a known amount or a known percentage. For example, if rent goes up 3% annually, GAAP rent could be used; however, if rent goes up by the CPI (which is an unknown amount and can vary), GAAP rent should not be used.

Since taxes are based on the P&L, one needs to account for the rent properly in order to calculate the taxes correctly, which is necessary to compare the true Net Present Value of the AfterTax Cash Flow.

Two additional key differences between P&L and Cash Flow are Capital/Depreciation and Timing. Companies (and the IRS) categorize costs as Expense and Capital.

Capital is typically a one-time cost and if it has a useful life of more than one year it may be capitalized. Note that different companies have different rules about what is capitalized vs. being “expensed,” assuming a useful life of more than one year (furniture for example). Typically the break point is determined by the cost. The IRS rule is an asset is capitalized if the life of the asset is greater than one year and the cost is greater than $100. However, companies have agreements with the IRS that increase the $100 rule; in some cases as high as $25,000.

When a cost is Capitalized, the total cost is NOT shown in the first year in a P&L analysis. Instead, the cost is depreciated and spread out over some period of time. Note that there are a number of ways to depreciate the costs such a straight-line, double declining balance, etc. The tax department in a company determines the approach, and the approach may be different between the Tax Return and what is reported to Wall Street as the P&L. For simplicity and ease of understanding, using straight-line depreciation (that is dividing the cost by the number of months of its useful life) is typically best for corporate real estate financial analysis.

Timing is everything. The P&L does not show Capital as a lump sum, but instead shows the cost as depreciation over some period of time. Assume you are spending $1 million to construct the interior improvements for a 10 year lease, thus the depreciation would be $100,000 per year ($1 million divided by 10 years).

In a Cash Flow analysis, the $1 million shows as a cost in the first year, but in a P&L analysis, only the depreciation, the $100,000, shows as a cost in the first year. So, in comparing the Cash Flow to the P&L analysis, the Cash Flow is $900,000 higher than the P&L ($1 million less $100,000).

Relationship Between P&L and Cash Flow

There are three fundamental parts to a companies financial reports – the P&L, a Cash Flow statement, and the Balance Sheet, and they are all related.

Assume you sell a widget for $1,000 and your cost of selling the widget is $600. In a typical P&L report, the $1,000 is recorded as a sale and $600 is a cost, leaving a profit of $400. This profit is shown as soon as the product is shipped, not when the bills are paid and the sales revenue collected.

In a simple transaction, the $1,000 is shown on the Balance Sheet and Cash Flow Statement as an Account Receivable and the $600 cost is shown as an Account Payable.

When the customer pays and the $600 cost is paid, the Cash Flow statement is updated to show the the additional $400 and the Balance Sheet is updated to show the $400 as cash and as retained earnings.

The key is timing – on the P&L, the profit is shown as soon as the product is shipped. However, on the Cash Flow and Balance Sheet the net cash is not shown until all bills are paid and the customer has paid for the product.

Special Considerations

Taxes are based on the P&L, not on Cash Flow. Consequently, you need to calculate the P&L before you can calculate the taxes. And, to calculate the P&L, you need to categorize costs as Expense or Capital, and then show the depreciation of the Capital costs in the P&L calculation. The P&L does not show Capital as a lump sum, but instead shows the cost as depreciation over some period of time.

When calculating P&L, it is vitally important to measure the P&L based on a company’s fiscal year for reporting financial results.

The fiscal year can be a calendar year, January through December, or it can start at any month in a year. For instance, most Japanese-owned companies have a fiscal year that starts in April and ends in March, while the federal government has a fiscal year that starts in October and ends in September.

Showing a P&L analysis in Lease Years (Year 1, Year 2, etc.) can be extremely misleading. For instance, if a lease starts in October and a company has a calendar year fiscal year, then only three months of the P&L costs will impact the first fiscal year, not twelve months if an analysis uses Lease Years.

For instance, in the earlier example of a $1 million capital expenditure depreciated over 10 years, on a P&L basis only three months of depreciation would show in the first year, a $30,000 cost vs. a $100,000 cost in a Lease Year analysis.

Financial Metrics

The key financial metric in corporate real estate financial analysis depends on who is measuring and priorities. Usually when companies say that “Cash is King!” the key metric is capital.

Profitability is key. If profitability is the most important metric, then measuring and comparing the Pretax P&L impact is most important. Sometimes the key is the first year P&L impact, other times managers want to compare the P&L by year.

It is important to note that other than retail, corporate real estate is a cost to a company and there is no profit unless space is purchased and later sold assuming appreciation of the asset. When space is leased, the cost goes right to the company’s bottom line. The theory is that the occupants of the building (staff, manufacturing, etc.) will generate a profit that will offset the cost of the real estate. Consequently, most P&L and Cash Flow analyses for corporate real estate do not include any profit and just show the occupancy cost of the space.

Click to enlarge

In general, CFOs make comparisons based on the Net Present Value of the AfterTax Cash Flow. However, depending on priorities, they may also compare the P&L impact and the capital required. Business unit managers who are charged back the cost of their space look for the Pretax P&L impact in both the current fiscal year and over the term of the lease.

The Bottom Line

Companies have at least two bottom lines – the bottom line for P&L (the number reported for profitability) and Cash Flow (the actual cost that represents money actually spent).

When doing a financial analysis, one needs to look at both numbers. Depending on a company’s priorities at that time, the P&L can be more important than Cash Flow.

For individual managers, whether corporate real estate managers or the business unit manager, the Pretax P&L represents the cost that is charged to their operating budget. The Pretax P&L is the budget cost with which they are measured by management, and frequently a key measurement in their bonus plan.

So, help yourself and your customers by being sure to calculate the P&L impact as well as the Cash Flow when comparing properties and doing your financial analyses.

Jim’s next Blog –>GAAP Sublease Rent is coming soon.

The term “Integrated Workplace Management Systems” or “IWMS” was coined by Michael Bell formerly of The Gartner Group. This new term was then used as the basis for producing an IWMS market assessment including a Gartner Magic Quadrant. This type of assessment is commonly produced by Gartner to compare technology vendors in many industries. Without a common term, in this case IWMS, there would have been no way to ‘lump’ a bunch of vendors together into a comparison document. In reality, at the time the term was coined, the vendors thrown into the IWMS bucket were very dissimilar and often addressed very different markets. Since then, however, using the IWMS blueprint provided in the IWMS market analysis containing the Magic Quadrant, the vendors have actually enhanced their products, changed messaging and in some cases merged to better fit the image of “IWMS”. While features of the vendors have grown more similar, they remain different in some very important ways, most notably their expertise in specific customer bases and specific functionality that addresses that base.

I for one, have worked for two IWMS vendors and competed in the market since long before the term was coined, having co-founded Lucernex in 2000, then taken over as CTO and head of product management at Accruent in 2003 then returned to Lucernex to become President. I have seen most of the vendors products, have talked to any number of people who have worked for the different vendors and seen marketing and Blogs from many vendors. We all seem to be trying so hard to fit the mold of “IWMS” when really we should be distinguishing ourselves based on our unique knowledge and features.

If you look at the key vendors in the space in addition to Lucernex you will find Accruent, Tririga, Manhattan, Siterra, Planon, amtdirect, Bricsnet, Qube, BIG, FM Systems and many more. What’s most interesting is that there are enormous differences between these vendors both in their background and expertise and in the functionality that they deliver, yet we are all “IWMS” vendors. For example, Lucernex leadership came from commercial real estate, retail, hospitality and corporate technology. Our products reflect that as we are very strong in site selection, lease analysis, transaction management, construction project management, lease administration and capital project management. Our knowledge of prototypical development design, planning and management as well as lease administration and rent accounting is second to none among “IWMS” vendors. If you look at each of the other vendors you will find a variety of other specialties as well.

The easiest way to assess what an IWMS vendor is best at is to look at the background of the leadership. If all executives of an IWMS firm come out of construction management, you can bet their construction project management features are really good. If their leadership came from real estate brokerage, their site selection and lease management features are likely their best functions. Strong facilities management is likely to come from someone with a background in corporate or campus property management. No one vendor is best at everything and, no matter what any vendor says, no one is best to fit every customer.

My hope is the market will begin to segment and become redefined by what is really needed by the different end user communities. After all, what is needed by a 200 store retailer is not the same as what is needed by a University with 2 campuses, or a corporation with 5 locations, or a government agency with 300 global locations, or a restaurant chain with 20,000 locations worldwide, or a cell phone company with thousands of towers and hundreds of stores. I look to organizations like IWMSNews and FacilityLeadership to begin to dissect the market instead of simply picking up where Gartner left off.

Some vendors have already begun to move away from the pure IWMS moniker. At Lucernex, for example, we still use the IWMS tag for our solution but truly consider our offerings to be Location Performance Management or LPM software. Qube software and amtdirect don’t use the IWMS name at all and Accruent has begun to use Enterprise Location Management or ELM to describe their solutions (though this may change due to the recent purchase of Accruent by a Private Equity firm).

We need new thought leaders whose agenda is not to lump us all together to be able to write a single report trying to compare us all against a single set of requirements. Instead, identify the needs of the different end user communities, see what features and functions are most important to them and how they need them delivered and compare the vendors to those requirements. What I believe we would find is there are several strong vendors in the IWMS market that are the best at serving one or two groups of user communities which would make it easier for buyers to know what is available to them and which vendors to compare.

I welcome additional opinions from customers and other vendors.

Go to our Lx IWMS product page to find out more about the Lucernex IWMS.

Joe’s next blog topic –> IWMS? Its all about the Location!

Accruent’s Store Lifecycle Management (SLM) product sold to dozens of retailer and corporate users since 2004 came about due to a license sold to Accruent by Lucernex in 2003 allowing Accruent to market the Lucernex IWMS solution under the Accruent name. The core of the Accruent solution remains, in large part, the 3.81 version of Lx IWMS. Lucernex has since updated the location performance management software and is now at version 7.0 having made vast improvements in the capability. The former creator of SLIM, Ken Brown, is now in charge of Lucernex product design and development after selling the SLIM product and his company, National Facilities Group, to Accruent in 2003. As a result Lucernex can provide the smoothest transition for current Accruent clients.

No first year software cost!!

To make this easy to budget, Lucernex will convert any Accruent client to Lx IWMS and charge no first year fee for the software. In addition, as a conversion from Accruent is really more of a simple upgrade into the newer version of Lucernex, our professional services team will charge a simple cost plus 20% for the project.

No one can convert you from Accruent faster, cheaper or more accurately than Lucernex!

Please use our Product Information page if you are interested in talking to an Lucernex representative about our Accruent upgrade.

While no one can say for sure, it appears based on the recent positive GDP announcement, that the U.S. economy has bottomed out and we are now in the midst of what may be a longer and slower recovery when compared to past economic recessions. The events of the past 24 months have forced growth-minded real estate companies to re-examine or retool their business models to optimize efficiencies and harness opportunities. Economists believe future growth is expected to come from overseas markets, especially Asia and the “BRIC” nations (Brazil, Russia, India, and China).

Many corporate and retail real estate companies are using this opportunity to expand globally into Asia, Europe, and the BRIC nations. New stores are opening and new manufacturing facilities are under construction. There are many reasons for this shift. Growth in the United States is not expected to be as strong as projected growth from the emerging markets. And, the financing markets may be more receptive to opportunities in these faster growing regions of the world. As part of a push by companies to tap into global growth, companies must accordingly adopt a strategy to “globalize their corporate real estate portfolio.

However, moving into foreign and emerging markets does not come without risk and challenge. In order for any company to operate a global real estate portfolio, they need to be able to standardize and track the real estate lifecycle process. This may span several different countries and include different languages, currencies, time zones, and measurement systems.

As an example, imagine a United States headquartered corporation with manufacturing facilities opening in Brazil, China and Canada. How is this United States-based company expected to be able to track the development and eventual operation of these different facilities in real-time, and be able to actively manage all processes? At Lucernex, we believe it is critical to implement a system that will standardize all variables for a company’s global real estate portfolio. The newest version of IWMS software can do just that – easily track and standardize currency, measurements and time zones. And, this software will also help a company better track its leases, costs, and employee count, too. Lx IWMS also now has Lx LseMod software integrated providing fully internationalized lease analysis using any currency or measurement with all results flowing automatically into Lx IWMS site selection module for optimal decision making.

Companies using Lucernex applications are actively benefiting from these tools and have found the value and efficiency it provides to be critical to the real estate development and management process. In today’s emerging global real estate business, if an IWMS system cannot handle a company’s complete portfolio, that company is at an extreme disadvantage.