I have blogged previously about the tentative nature of the efforts between the FASB / IFRS. To some of you this has may have appeared harsh, while to others, it likely seemed an accurate view of FASB/IFRS positioning. In my reading of changes to the FASB/IFRS position, it true that FASB and IFRS are making progress. The most recent accomplishments from the recent meetings of these two groups are:

Lessor Accounting
The Boards continued their discussions on the single approach to this issue, which recognizes a lease receivable and a residual asset at lease commencement. Of course, this approach raises additional issues and results in new considerations. Notably, the issues of profit recognition at lease commencement and whether there is a difference when only a portion of the asset is leased and not the entire asset.
Hence, profit recognition is an issue when:

• An owner sells
• An owner leases, or
• A tenant leases (i.e. subleases) their property.

Subleases

• The Boards seem to be headed in a consistent direction on this topic. There will be a “head lease” and “sublease” in a subleasing transaction and as such they should be accounted for as separate transactions.
• In the sublease transaction, the tenant becomes the sub-landlord, and, hence, should look to the Lessor Accounting rules for any necessary clarification of the right-of-use asset in this situation.

Short-Term Leases

• It’s simple. If the lease has a term of 12 months or less, including all its options, it will be recognized on a straight-line basis on the P&L. Of course, since accounting is as much art as it is science, if another recognition pattern makes sense within the year … use that method instead.
• The Boards also expressed support of disclosure of the repetitive nature of any short-term leases

Lastly, they discussed the unique issues related to the issue of Shariah-Compliant leases under the right-of-use model. And while nothing was decided, the simple fact that the group understands the necessary appropriateness of discussing the implication here is a testament to their commitment to the do the right thing. And we commend them!
We look forward to the Boards next update and we hope you look forward to our next update as well.

Shameless Plug

Lucernex has updated the financial engine that powers our Lease Administration / Rent Accounting and Lease Analysis solutions to support the pending changes to FASB/GAAP rules. As a result our Lx Contracts and Lx LseMod products can provide an analysis of the new vs. the old rules and can support 12 and 13 period accounting based on both the old and the new FASB rules.

Previous Blogs By Mike

CoreNet … “There is no opportunity like a crisis!”
“Tentative” – The FASB IASB word of choice!

Past Blogs by Jim Duport

Thoughts on the proposed FASB GAAP lease accounting changes
5 GAAP Rules you need to know
GAAP in Commercial Real Estate Sublease Accounting
Go Beyond a simple and potentially misleading Cash Flow analysis
What is GAAP rent and how does it impact SOX?
Sale Leaseback transactions
The proposed FASB changes and the impact on the lease vs. buy decision
When is the Proposed NEW FASB / GAAP Cheaper in Year 1 vs. Old GAAP?
Renewal probability and the New FASB Rules

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.”

Shameless Plug

Lx LseMod Corporate Lease Analysis is the market leading application for Corporate lease analysis, providing GAAP sublease impact analysis within detailed P&L and Cash Flow projections. Companies like GE, MetLife, American Express and Robert Half use Lx LseMod Corporate for lease analysis making it the most trusted name in corporate lease analysis.

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