The Ultimate Handbook for New FASB Lease Accounting ... · The Ultimate Handbook for New FASB Lease...

The Ultimate Handbook for New FASB Lease Accounting Guidelines For Commercial Real Estate Leases

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1. Introduction 22. How to Capitalize a Commercial Real Estate Lease 33. Creating a Capitalization Schedule 134. Creating a Financial Statement Report 295. Restating Your Lease Obligation 306. Brief Background 317. How to Prepare Now 328. About Us 33

TABLE OF CONTENTS

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Countless white papers have been written to address the new proposed FASB/IASB lease accounting guidelines. The majority of these white papers have discussed high-level topics such as general preparations and status reports. Unfortunately, none of the white papers have addressed the real details of how leases will be capitalized in accordance with the new guidelines….until now!

This handbook will be the first of its kind to show the specifics of how commercial real estate leases will be capitalized using the FASB Type “B” method of capitalization for Operating leases. You do not need any accounting background to understand the concepts explained in this book. It was written specifically for corporate real estate executives, brokers and lease administrators. Anybody can learn how to capitalize a lease regardless of what your background is. This book will teach you what variables you will need to capitalize a lease and it will walk you through the calculations step-by-step so by the time you are done reading this book you will be an expert at capitalizing leases.

Our findings detailed in this handbook are based on five years of research and testing by the ProLease development team and our consultants. We have also reviewed our conclusions and questions in face-to-face meetings with the FASB (Financial Accounting Standards Board – Norwalk, CT) and IASB (International Accounting Standards Board – London, England). Please note that this handbook was written in April 2015 and is based on what we know today. Neither FASB, nor the IASB have finalized exactly how capitalization of leases is going to happen. We hope to get the final word by end of 2015. Once it is finalized, if any changes need to be made, we will release an updated version of this handbook.STAY TUNED!

1. INTRODUCTION



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2. HOW TO CAPITALIZE A COMMERCIAL REAL ESTATE LEASE(Written in plain, English for people who have no accounting background or MBA.)

We promised NOT to reiterate and bore you with the same high-level information that every other white paper gives you, so this section will get right into teaching you how to capitalize a lease. For those of you who want to read about the background of FASB/IASB’s Leases project and Lease Capitalization, you can skip to section six of this handbook.

DISCLAIMER – The FASB and the IASB do not create “rules.” They create “principles” based on accounting standards. It is up to each company (and their auditors) to implement these principles. This means that there is no step-by-step instruction manual on how to capitalize a lease for every possible scenario that you might be negotiating. Once you understand all the concepts outlined in this handbook, you will be able to discuss potential challenges and questions with your auditor or accountant to make sure your capitalization methods will pass their acid test. At ProLease, our tech support gurus are here to guide you and answer your questions, but you should consult with your auditor or accountant about the best practices for your company.

IMPORTANT – There are two ways to capitalize a lease. They are referred to as:

1) TYPE A – I & A Method / Interest & Amortization (applies to what we now call capital leases)

2) TYPE B – SLE Method / Single Lease Expense (applies to what we now call operating leases)

Almost all commercial real estate leases will be capitalized using the Type B - SLE Method. The only real estate leases that will be capitalized using the Type A – I & A method will be any lease that passes at least one of the following four tests:

TEST #1) If title transfers at the end of the term TEST #2) If there is a bargain purchase option at the end of the term TEST #3) If the lease term is ≥75% of the useful life of the asset TEST #4) If the PV of the rent payments is ≥90% of the FMV of the asset

The reality is that only leases that are long-term, triple net leases for the entire property, will be capitalized using the Type A method. Office tenants in multi-tenant office buildings and retailers that have stores in strip centers and malls will be capitalizing their leases using the Type B – SLE method.


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FUN FACT - All land leases are considered “Operating Leases.”

This book walks you through capitalizing a lease using the Type B – SLE (Single Lease Expense) method.

BIG PICTURE OF CAPITALIZING A LEASEFirst things first: You need to understand the big picture concept of capitalizing a lease. When you capitalize a lease, the asset appears on your balance sheet as if you had bought it. The balance sheet is all about Liabilities & Assets. You will create a “Lease Liability” and a “Right of Use Asset” (ROU Asset) for each lease.

FUN FACT - It is important to note that Type A and Type B assets and liabilities will be reported separately on the balance sheet as they are very different legal agreements – meaning you “own” a Type A asset but you are just “renting” a Type B asset.

The starting value of both the Lease Liability and ROU Asset will be the present value (PV) of the lease payments. You will then amortize that PV down to $0 over the capitalization term using different methods of amortization for the Lease Liability and the ROU Asset. It is important to note that the ROU Asset will have other components added to it that will not affect the lease liability. For example, Landlord Allowances, Initial Direct Costs and Impairment charges. This will all be discussed later in detail. For now, suffice it to say that the Lease Liability and the ROU Asset start with the PV of the lease payments and amortize the PV down to $0 using different methods of amortization.

When you sign a lease, you will create a capitalization schedule for that lease. Once that schedule is created, you will never need to touch the capitalization schedule again unless “something changes your financial obligation,” meaning, the lease is modified or the rent payments change. If your financial obligation changes, you must “Restate” your lease obligation from the date you recognize the change to the end of the term. Here are a few examples of things that will cause your financial obligation to change mid-term:

• Expanding (taking additional space) • Contracting (giving back some space) • Renewing your lease for a longer term • Cancelling your lease early • Rent increases due to an outside index (CPI Escalations) • Receiving TI payments from a landlord



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So there you have it. The basic concept of capitalizing a lease is to calculate the present value of the lease payments, create a Lease Liability and an ROU Asset, and amortize them both down to $0 using two different methods of amortization. You’re done. If anything changes your financial obligation during the term of the lease, you will restate your lease obligation. Sounds easy enough, but the devil is always in the details. READ ON!

WHAT INFORMATION DO I NEED TO CAPITALIZE A LEASE? Excellent question. It would be silly to attempt to capitalize a lease if we did not have all the information necessary to capitalize a lease.

I always tell my clients, “Having the right tools for the job, makes the job much easier.” When capitalizing a lease, having the right tools means having all the information you need to capitalize the lease before you try to start making the calculations. This section outlines the 7 pieces of information you need to capitalize a lease. You will need to know:

A) What Term Do I Capitalize the Lease Over? B) The Costs/Rent Payments to be Capitalized C) Discount Rate D) Landlord Allowances E) Deduct Service Portion of Your Rent F) Initial Direct Costs (IDC) G) Impairment Charges

Each of the above is explained in detail below.

A) WHAT TERM DO I CAPITALIZE THE LEASE OVER?It would be impossible to start any lesson in capitalization without explaining the term to capitalize leases over. There are four factors that will affect the capitalization term:

1) Is This a New Lease or a Renewal? 2) The Actual Lease Term 3) Renewal Options 4) Cancellation Options


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FUN FACT - Short-term leases do not get capitalized. Short-term leases are defined as leases with a term of 12 months or less. They will be treated as “off-balance sheet” operating leases under current rules.

IF THIS A NEW LEASE… If you sign a lease for new space, i.e., you are NOT renewing a current lease, you will start the capitalization schedule on the commencement date of the lease.

IF THIS IS A RENEWAL LEASE… If you are renewing a lease, you will capitalize the renewal term from the date you sign the renewal, NOT the commencement date of the renewal term. For example, your current lease expires 6/30/2015 and in January 2015, you sign a new five-year renewal that goes from 7/1/2015 to 6/30/2020. You will create a capitalization schedule starting 1/1/2015 and it will go for 66 Months. The 6 months of remaining term on the existing lease 1/1/2015-6/30/2015 plus the new term from 7/1/2015-6/30/2020.

RENEWAL OPTIONS If your lease includes any renewal options, you might have to include the renewal option(s) in the term of your capitalization schedule. Current guidelines say that if you are “Likely” to exercise the renewal option, you will have to include it in the capitalization term. Defining “Likely” is the tough part. If there is an economic incentive or economic compulsion to exercising the option, you will be considered as “Likely” to renew. Economic incentive can have many meanings:

• Your renewal option is written at a significantly below market rate, e.g., 90% of FMV.

• Your usage is so specialized that it would cost a ridiculous amount of money to relocate (think factories, data centers, high tech lab space, etc.), so you are compelled to renew.

• Your space is built out at such a high-end installation, that it would cost too much to relocate, so you are compelled to renew.



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CANCELLATION OPTIONSIf you have a cancellation option and you are “Likely” to exercise the option, you only have to capitalize through the cancellation date. For example, suppose you signed a 10-year deal with the right to cancel after year 5. If you are “Likely” to exercise this cancellation option you only have to capitalize the lease for 5 years.

If you decide you are “Likely” to exercise the cancellation option and you have to pay a cancellation penalty, you have to capitalize the cancellation penalty amount today as if it were a part of your rent payments. For example, your lease is for 10 years and you have the right to cancel after year 5, but as a cancellation penalty you have to pay the unamortized amount of cash contribution, free rent, and commission. You will have to calculate that unamortized amount today and include it in the capitalization schedule as part of your minimum rent.

B) WHAT COSTS DO I HAVE TO CAPITALIZE?IMPORTANT – Understand this: your goal, from an accounting perspective, is to capitalize the least amount of rent possible so as to report lower amounts for the lease assets and liabilities (makes your financial statements ”look” better). Understanding which components of rent you will capitalize and which deductions you can take to reduce the rent to be capitalized is critical. This section outlines all of this.

The rent to be capitalized is your minimum fixed rent payments after free rent plus any increases in your rent. A few examples are:

• Base Rent (after free rent) • Any fixed bump increases, e.g., $.50 psf/per year,

$2.00 bump in year 5 • Fixed % increases, e.g., 3% per annum increases • *CPI Escalations • **% Rents – Retailers • ***Parking

FUN FACT - Variable expenses such as CAM, Operating & Utility Costs will not get capitalized in either a Gross or Net lease. However, in a Net lease, real estate taxes will NOT get capitalized but in a Gross lease the real estate tax base amount included in the base rent does get capitalized. Future real estate tax pass through’s will NOT get capitalized. Only the real estate tax base amount gets capitalized in a Gross lease.


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There are two ways to increase the base rent by a percentage. You can have either a fixed per-centage increase or a CPI escalation.

Fixed % increases are included in the initial present value calculation and are capitalized over the entire term. If you sign a 10-year deal with rent bumping at 3% every year, all 10 years of the 3% per annum increases are capitalized today.

*CPI Escalations – The way CPI escalations will be handled has recently changed. The FASB and the IASB are not in agreement and each has their own way to handle CPI Increases.

IASB Method – At the inception of the lease, you will NOT inlcude any CPI Increases in the initial Lease Liability or ROU Asset calculation. Each year when you get your CPI increase, you will have to restate your lease obligation as if the new rent amount (Base Rent + CPI Increase) is the rent that you will be paying over the remaining life of the lease.

FASB Method – At the inception of the lease, you will NOT inlcude any CPI Increases in the initial Lease Liability or ROU Asset calculation. In addition, each year when you receive your CPI Escalation, you will NOT have to restate your obligation to include the CPI amount. In an effort to make the process easier for Lessees, the FASB has decided to not make lessees restate their obligation each time a CPI increase is incurred.

The only time you will have to capitalize the CPI amount is if you restate your lease obligation for some other reason (i.e. you have expanded your space or extend your term in the middle of the lease etc.). If you have a CPI escalation and you never restate your obligation over the entire term, you will never capitalize the CPI amounts in that lease. You will only capitalize the CPI amounts if you restate your obligation during the term. When you restate your lease obligation you will include the current escalated rent (Base Rent + CPI Increase) as if that was the rent for the remainder of the term. You do not capitalize future estimates of CPI. Only capitalize the current amounts.

**% Rents : If a retailer is paying a market base rent and additionally has to pay a % rent escalation, they will NOT have to capitalize the % rent. If they are paying a below market base rent, as well as a % rent, they will have to capitalize an estimate of the % rent. The goal of capitalizing operating leases is to give the reader information on what the lease liability is. In cases where it is obvious that the below market rent will be “made up for” through reasonably assured % rents, you will have to capitalize the % rents.

***Parking costs only have to be capitalized if the spaces are designated.

IMPORTANT – If you are required under the guidelines to capitalize an option period (as you have a significant economic incentive or compulsion to exercise), and the rent for the option period is written as 95% of fmv, someone in your company is going to have to assume/estimate what the rent will be during the option period.



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C) DISCOUNT RATEThe discount rate is used for two calculations:

1) To calculate the present value of the rents to be capitalized (Starting point for Lease Liability and ROU Asset)

2) To calculate the interest on the Lease Liability

FUN FACT - This is a good place for a quick discussion on calculating Present Value. You can calculate Present Value in 4 ways:

Because rent is due MONTHLY at the BEGINNING of the month, I suggest you calculate your PV that way. ProLease always calculates the PV on a MONTHLY basis, but gives you the option to do it either at the BEGINNING or the END of the month. ProLease will not calculate ANNUAL PV.

Current guidelines say that a tenant should use their incremental fixed rate cost of borrowing under a loan for a like term at the commencement date of the lease. If you are signing a 5 year lease, use your 5 year borrowing rate. If you are signing a 10 year lease use your 10 year borrowing rate. If, during the term of the lease, something changes your financial obligation, you need to “Restate” your obligation. When you “Restate” your obligation, you must use the SAME discount rate as previously used. The only time you can change the discount rate is if you are restating your obligation and you are changing the term of your lease (making it longer or shorter).

• MONTHLY assuming a BEGINNING of month payment• MONTHLY assuming an END of month payment• ANNUALLY assuming a BEGINNING of year payment• ANNUALLY assuming an END of year payment


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D) DEDUCT SERVICE PORTION OF YOUR RENTDeductions allow you to reduce the amount of rent you will be capitalizing.

FUN FACT - We love deductions.

The guidelines say that you can deduct (aka bifurcate) any portion of the rent that you are receiving a service for. Examples of this type of deduction would be:

OPERATING BASE AMOUNT (GROSS LEASE ONLY) – Gross leases are when you have a base year for operating expenses. If you have a 2015 operating base year and the 2015 operating base amount is $6 per square foot, you only have to pay the increases over the $6 base amount each year. The landlord has built this $6 base amount into your base rent. $6 of your annual base rent is going towards paying the operating costs in the building. You are receiving a service for this $6 so you can reduce the rent to be capitalized by $6 per square foot per year.

IMPORTANT – You cannot reduce the rent to be capitalized by future operating payments / increases. You can only reduce the rent by your operating base amount in the base year. If you were paying $30 per square foot in a 5-year lease, and the operating base amount was $6 per square foot, you would only have to capitalize $24 per square foot ($30 - $6 = $24).

UTILITIES – If you are doing a “full service” deal where the rent includes your utilities (Electric, Gas, Water, Sewer, etc.), you can deduct that amount from your rent to be capitalized.

IMPORTANT – You cannot take these service deductions in months where you have free rent. In addition, if you have partial months of free rent (half-a-month), the monthly deduction amount cannot exceed the rent you are paying in that month. ProLease and ProCalc automatically takes care of this for you.

IMPORTANT – Suppose you signed a 5 year deal with a 5 year renewal option. Let’s also assume you have a significant economic incentive (bargain or compulsion) to exercise that renewal option, so you will now be creating a 10 year capitalization schedule. You negotiated a 2015 base year for Operating expenses and the 2015 base amount is $6.00 per sq ft. However, when you renew your lease in 5 years you will get new base year (2020) for operating expenses the base amount will be something higher than the current $6.00 per sq ft. This means you can take a higher deduction starting in the year 2020 for Operating expenses. You will have to make an assumption as to what the operating expenses will be in 2020. While there is no way to predict the exact amount, if you looked at the historic increase rates and calculated an average over the last 5 years, that would be a good way to project the future amounts.



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E) LANDLORD ALLOWANCESLandlord allowances are defined as any cash payment the landlord gives you. Examples of landlord Allowances would be a TI Allowance, Moving Allowance, Architect Allowance, Wiring & Cabling Allowance, etc.

IMPORTANT – Landlord allowances have no effect on the lease liability. They are deducted from the ROU Asset only. We love deductions!

IMPORTANT – You can only deduct landlord allowance amounts from the ROU Asset when you receive them, NOT at the commencement of the lease. For example, suppose a landlord agrees to reimburse you for your construction costs. The lease states that, “upon supplying the landlord with paid receipts and waivers of liens, the landlord will reimburse you up to $250,000 for your construction costs.” Let’s assume that 6 months into the lease you put together $50,000 of receipts and you receive a check from the landlord. You would re-state your lease obligation from month 6 until the end of the term showing this $50,000 payment from the landlord as a reduction in the ROU Asset. Each time you receive a new payment from the landlord, you will restate your obligation showing the allowance as a reduction in the ROU Asset. You cannot deduct the full $250,000 from your rent on day 1.

F) INITIAL DIRECT COSTS (IDC)Initial Direct Costs (IDC) are defined as any payment made to a third party by the tenant that is directly attributable to the negotiation of the lease. Common examples of IDC’s would be:

• Legal Fees • Broker Commissions • Consulting Fees

IMPORTANT – Initial direct costs have no effect on the lease liability. They are added to the ROU Asset only. The costs are not a deduction. They increase the ROU Asset amount.


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G) IMPAIRMENT CHARGESImpairment is defined as when your asset is no longer worth what your asset value is on your balance sheet.

IMPORTANT – Impairment has no effect on the lease liability. It is a deduction from the ROU Asset. We love deductions!

The most common example of an impairment charge will be subleasing space at a loss. Suppose you downsize your business and you have some excess space that you are going to put on the market to sublet. The value of the ROU Asset is now less so you have to take a current charge to P & L and the resulting credit reduces the ROU Asset. This reduction of the ROU Asset is written off against rent over the remaining lease term.

To calculate the impairment amount you would calculate the present value of your remaining liability and subtract the present value of any subtenant income (After any concessions including free rent, TI and commissions). When calculating the PV, use your incremental borrowing rate as a discount rate.

IMPORTANT – If you are subleasing space at a profit, there is no impairment charge. You must be losing money for there to be an impairment charge.

IMPORTANT – To calculate the impairment charge today, you must make an assumption about when you will find a subtenant and how much they will pay. If, when you actucally sign the subtenant deal you need to change the impairment amount, you can adjust it (either up or down) at any time.



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• The “Lease Liability” will start with the present value and get amortized down to $0.

• The capitalized lease asset (ROU Asset) will also start with the present value and get amortized down to $0 using a different method of amortization than the lease liability.

Now that you understand the 7 pieces of information you need to capitalize a lease, we are almost ready to start going through the calculations to capitalize a lease.

Before we get into these incredibly complex calculations that this book is going to make so easy for you to understand, let’s look at the big picture. For a Type B operating lease (typical commercial real estate lease):

3. CREATING A CAPITALIZATION SCHEDULE

Both ProCalc and ProLease make it unbelievably easy for you to enter the 7 pieces of information outlined in section 2 of this book. Once the information has been entered, the Lease Liability and right of use asset will automatically calculate. No further work from you is necessary. Enter the 7 variables and like magic, your lease is capitalized. LET’S DO IT!


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Time to capitalize a lease. First we need to create a lease scenario. I am going to keep this to a 3 year lease so that I will be able to show you what a report would look like for the entire term on a single page.

ASSUME THE FOLLOWING TERMS FOR OUR SAMPLE LEASE:

Lease Term: 6/1/2015 – 5/31/2018 • This is a new lease, NOT a renewal hence, the capitalization term will be the same 3-year term. • No renewal or cancel options are included in this term

Rentable Area: 10,000 SF

Base Rent: Year 1 $240,000 Per Year / $20,000 Per Month Year 2 $247,200 Per Year / $20,600 Per Month Year 3 $254,616 Per Year / $21,218 Per Month

Free Rent: 2 Months (6/1/2015 – 7/31/2015)

Discount Rate: 6.00%

Service Portion of Rent Deductions: Landlord Allowance:

Initial Direct Costs: Legal Fees $10,000 Impairment Charges: None

Okay, that’s everything we need to know to capitalize this lease. We now have the right tools for the job. Let’s get busy calculating.

I Will Break the Process of Capitalizing a Lease Out Into 3 Easy Steps:

STEP 1: Calculate the costs to be capitalizedSTEP 2: Calculate the Lease LiabilitySTEP 3: Calculate the ROU Asset

The landlord has agreed to reimburse us up to $100,000 for our construction costs. The landlord has agreed to give us $40,000 on the commencement date and the other $60,000 will be paid upon us supplying the landlord with paid receipts and waivers of lien. This means we can only deduct the $40,000 we receive on the commencement date because we do not know when we will receive the other $60,000.

We have a 2015 base year for Operating. The monthly operating amount is $7,500.



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STEP #1) CALCULATE THE COSTS TO BE CAPITALIZED


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STEP #1) COSTS TO BE CAPITALIZED — EXPLANATION OF COLUMNS

REMAINING MONTHS, MONTH # AND DATE We have a 36-month lease. These columns are self-explanatory.

RENTABLE AREA This column has no effect on the calculations. It is just there as a reference so people will know what the rentable area is. It is good to include in the report because if the rentable area changes in the middle of the term, people will be able to see that in this column.

A) BASE RENT This is the monthly rent outlined in our deal. Notice there is no rent in the first 2 months because we got 2 months of free rent.

B) MONTHLY SERVICE RENT DEDUCTIONSThis is the $7,500 monthly Operating Base Amount that we are deducting from the rent to be capitalized. Notice there are no deductions in months 1 & 2 because we have free rent. The monthly service deduction cannot exceed the amount of rent you are paying in that month.

C) TOTAL RENT AMOUNT TO BE CAPITALIZEDThis is the sum of the 2 previous columns (A + B). We now know that after all deductions, we are capitalizing $446,816.00.

MPORTANT – This is also the cash stream we will calculate the present value on to get the starting point for the Lease Liability and Right of Use Asset.



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STEP #2) CALCULATE THE LEASE LIABILITY


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STEP 2) CALCULATE THE LEASE LIABILITY — EXPLANATION OF COLUMNS

C) TOTAL RENT AMOUNT TO BE CAPITALIZED (A + B)This is the same column that was in the previous section. I left it in here as a reference point for you. This is the cash flow we are using to calculate the PV.

REMAINING PRESENT VALUE OF COLUMN C AT 6.00%The first step in calculating the Lease Liability is to calculate the PV of the total rent to be capitalized. This is the column that calculates the Present Value. It uses the 6.00% discount rate we have discussed and calculates the PV of Column C (Total Rent Amount To Be capitalized). You can see that the present value of the $446,816.00 cash flow is $407,221.63 (the PV in month #1). This PV is the starting point for calculating the lease liability.

FUN FACT - For all of you spreadsheet jockeys and HP-12C gurus that are trying to get the same PV number as I am, remember that you must calculate the Present Value MONTHLY assuming a BEGINNING of month payment. I promise you this number is correct when calculated properly. If you are getting a different PV it is probably because you are not doing it MONTHLY assuming a BEGINNING of month payment.

D) INTEREST ((PV – TOTAL RENT) X 6.00%)/12The interest calculation in month #1 starts with the PV ($407,221.63) and goes as follows:

((PV - Total Rent to be capitalized in month 1) x 6.00%) /12 IN NUMBERS, THE INTEREST FOR MONTH #1 LOOKS LIKE THIS:

$407,221.63 - $0 = $407,221.63 $407,221.63 x 6.00% = $24,433.30 $24,433.30 divided by 12 = $2,036.11 (Interest in Month #1)

LEASE LIABILITY CLOSING BALANCE (REMAINING PV + INTEREST) – TOTAL RENT You need to calculate the closing lease liability balance at the end of each month. The calculation for the closing Lease Liability balance in each month is as follows:

(Remaining PV + Interest) – Total Rent to be capitalized

IN NUMBERS, MONTH #1 LOOKS LIKE THIS:

$407,221.63 + $2,036.11 = $409,257.74$409,257.74 - $0 = $409,257.74 (Lease Liability closing balance in month #1)



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STEP #3) CALCULATE THE ROU ASSET

FUN FACT – Notice how the Lease Liability closing balance is $0 in the last month (month 36). The Lease Liability must amortize down to $0 at the end of the term.

LEASE LIABILITY CALCULATION FOR MONTH #2After month #1, the opening balance in each month is the closing balance in the previous month. For example, the opening balance in month #2 is the closing balance of month #1.

If you continue to do the same calculations in every month to calculate the interest and the lease liability closing balance, the lease liability will go down to $0 at the end of the term (Month 36) as shown in the screen shot above. You can check all 36 months if you want. That will be a good way to make sure you really understand the calculation for the lease liability.

Remember, we started with the PV and amortized it down to $0 at the end of the term.

The ROU Asset will start with the same PV amount as the Lease Liability ($407,221.63) but, in addition to that PV, there are 3 other components that must get included in the ROU Asset calculation. They are:

• Landlord Allowances • Initial Direct Costs (IDC) • Impairment

FUN FACT – Landlord Allowances and Impairment charges will always be negative amounts hence they reduce the amount of the ROU Asset. Initial Direct Costs are expenses to the tenant (Positive Amounts) and thereby increase the amount of the ROU Asset.

So to calculate the ROU Asset we will need to create 4 separate sections as follows:

• Landlord Allowance• Initial Direct Costs (IDC)• Impairment• ROU Asset

Let’s start with the Landlord Allowance.


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SAMPLE LANDLORD ALLOWANCE AMORTIZATION



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LANDLORD ALLOWANCE CASH AMOUNT Remember our lease said the landlord would reimburse us up to $100,000 for our construction costs, but they agreed to give us $40,000 on the commencement date of the lease. Since we do not know when we will get the other $60,000 we cannot include it in this capitalization schedule. When we do get it we will have to “Restate” our obligation. For now we can only include the $40,000 Landlord TI we are getting on the commencement date of the lease.

IMPORTANT – If the tenant received any payments from the landlord prior to the commencement date of the capitalization schedule, those payments should all get rolled up and appear in month #1 of the capitalization schedule.

E) LANDLORD ALLOWANCE AMORTIZATIONThe Landlord Allowance gets amortized on a straight line basis (No interest) over the entire capitalization schedule term. In the example above it is $1,111.11 every month.

F) LANDLORD ALLOWANCE CLOSING BALANCETo calculate the closing balance in month #1 we take the $40,000 allowance and subtract one month of amortization ($40,000 - $1,111.11) and the closing balance in month #1 is $38,888.89.

In month #2 you take the closing balance of month #1 ($38,888.89) and subtract the amortization in month #2 and you get a closing balance of $37,777.78.

Continue this all the way down for 36 months and you will see the closing balance in the last month is $0.


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SAMPLE INITIAL DIRECT COSTS AMORTIZATION



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IDC CASH AMOUNTWe had $10,000 of legal fees that we were including as an Initial Direct Cost. We put it in month #1 of the deal. You can have IDC costs in any month of the deal. Anytime you have an IDC cost it will appear in the proper month in this column.

IMPORTANT – You might have paid legal fees prior to the start of the capitalization schedule. Any IDC costs paid prior to the capitalization start date should get rolled up into the start month.

G) IDC AMORTIZATIONThis is the $10,000 of IDC costs in month #1 being amortized on a straight line basis over the 36-month term. The monthly amortization amount is $277.78.

H) IDC CLOSING BALANCEWe need to calculate the closing balance in each month of the IDC cost. In month 1 we take the initial $10,000 and subtract the month 1 amortization of $277.78 to get a closing balance of $9,722.22.

In month #2 we take the closing balance of month #1 ($9,722.22) and subtract the amortization in month #2 ($277.78) and we get a closing balance in month #2 of $9,444.44. If you continue to make these calculations for 36 months, the IDC is amortized down to $0 at the end of the term as shown in the screen shot above.

IMPAIRMENTWe do not have any impairment charges in our deal so we will not be including that section.


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SAMPLE ROU ASSET



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IMPORTANT – As stated earlier, the ROU Asset starts with the present value. If you go back and look at the Lease Liability, you will see the present value is $407,221.63. If you look at the screen shot for the ROU Asset you will see the ROU Asset Opening Balance (PV Only) has the same $407,221.63 in month #1. That is the ROU Asset starting point.

Like The Lease Liability, The ROU Asset must be amortized down to $0 at the end of the term, but the method of amortization is completely different than the Lease Liability.

On the ROU Asset screen shot on the previous page, the two columns after the date column are labeled:

• Straight Line of Total Rent to be Capitalized • D) Interest ((PV – Total Rent) x 6.00%)/12

STRAIGHT LINE OF TOTAL RENT TO BE CAPITALIZED Take the total amount to be capitalized ($446,816.00) and straight-line it over the term and you get a monthly amount of $12,411.56.

D) INTEREST ((PV – TOTAL RENT) X 6.00%)/12 This column is a duplicate of the interest column in the Lease Liability section.

K) ROU ASSET AMORTIZATION (STRAIGHT LINE – INTEREST)This column shows the monthly amortization amount that will be used to amortize the PV down to $0 at the end of the term. It takes the straight line of the total rent to be capitalized and it subtracts the Interest from the lease liability (previous 2 columns). In month #1 the numbers to calculate the column labeled “K) ROU Asset Amortization” are as follows:

$12,411.56 - $2036.11 = $10,375.45

L) ROU ASSET CLOSING BALANCE (CURRENT BALANCE – AMORTIZATION) In month #1 we will start with the PV ($407,221.63) and subtract the ROU Asset Amortization ($10,375.45) and that will give us a closing balance of $396,846.18.

In month #2 we will start with the closing balance of month #1 ($396,846.18) and subtract the amortization in month #2 ($10,365.27) and we get a closing ROU Asset balance of $386,480.91.

If you continue making this calculation for 36 months the ROU Asset will be amortized down to $0 as shown in the previous screen shot.


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TOTAL ROU ASSET CLOSING BALANCEAs previously discussed, the ROU Asset is comprised of 4 components:

• Landlord Allowance • Initial Direct Costs (IDC) • Impairment Charges • ROU Asset

This column is where we combine the pieces of the puzzle to get the total ROU Asset. The screen shot below shows:

• F) Landlord Allowance Closing Balance • H) IDC Closing Balance • L) ROU Asset Closing Balance

If you add up these 3 columns in any month, you will get the Total ROU Asset Closing Balance. Notice ALL these columns go down to $0 at the end of the term.



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SAMPLE TOTAL REPORTED LEASE EXPENSE


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REPORTED LEASE EXPENSE / SLE METHOD (D+E+G+K)This is amount that will be booked as an expense an will be subtracted from your income to get your net income. It is calculated by adding:

• The Interest from the lease liability • The amortization of the Landlord Allowance • The amortization of the IDC Costs • The amortization of the impairment credit • The amortization of the ROU Asset

Looking at it another way, the process of accounting for the straight line rent expense is to accrue the average rent and pay the actual expense. This means in a stepped up rent schedule there will always be an amount of accrued rent payable.

Notice that the reported lease expense is the same in every month. This is why this method of capitalization is also known as the “SLE Method” or “Straight Line Expense” method.

CONGRATULATIONS! You have just capitalized your first lease!



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Now that we have done the calculations in each month, you will want to generate a report to show all of this information. We call this a “Financial Statement Report.” The sample report below covers you for everything your accounting department will want to know.

IMPORTANT – Notice the totals of rows A and B are the same. The cash amount and the P+L amount must always be the same.

4. CREATING A FINANCIAL STATEMENT


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5. RESTATING YOUR LEASE OBLIGATIONYou have now capitalized your lease based on what you know today. However, when something changes your financial obligation during the term of this lease, you will need to “Restate” your lease obligation from the date you realize the change until the end of the term.

There are many other challenges, when restating your lease obligation, but we can’t give away ALL of our secrets in this book.

If you would like to see how easy ProLease or ProCalc makes it to capitalize a lease and restate your lease obligation at any time, please give us a call to schedule a demo.

We are excited to hear from you.

John Unger Alan Bushell ProLease ProCalc203-274-9704 516-767-0120



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In July 2006, the FASB and the IASB announced a joint project to reconsider their standards on accounting for leases. Their primary purpose was to establish transparency for investors, as leases are currently being recorded as off-balance sheet transactions.

After much discussion, FASB and IASB released an initial Exposure Draft in August 2010 and second Exposure Draft in May 2013. After many comment periods and much deliberation, we are currently expecting FASB and the IASB to finalize their new lease accounting guidelines by the end of 2015.

Under the new proposed lease accounting guidelines, companies will be required to report all leases (except “short term” under a year) on the balance sheet as both a “Liability,” and an offsetting, “Right of Use Asset.”

THE EFFECT OF CAPITALIZING A LEASEUntil now, operating leases (the majority of real estate leases) have not been reported on company balance sheets. Rent payments have been reported as rent expense on a straight-line basis on the income statement.

With the new guidelines, when you capitalize a lease, it will appear on your balance sheet as if you had bought the asset, although what you have “bought” is merely a right to use the asset for the lease term. A capitalized lease increases the total value of the assets on your balance sheet. That affects a number of business ratios that creditors and potential investors use to evaluate your company’s profitability. It will reduce your company’s return on assets (the profit it generates for each dollar worth of assets) and its asset turnover (the sales generated for every dollar worth of assets). Because the lease also appears as a liability, it affects your liabilities to equities ratio, but the FASB decided that the operating lease liability will not be classified as debt – an important decision as it will not impact your loan covenants that limit the amount of debt you can incur.

We hope that Section 2 of this handbook has taught you how to capitalize a lease using the Type B – SLE method of capitalization. If you are a corporate real estate executive, an accountant, an auditor or a broker doing work with tenants, you need to understand how to capitalize a lease. As we like to say, “This is where the rubber meets the road.”

6. BRIEF BACKGROUND


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7. HOW TO PREPAREAs of March 2015, we are confident that the new FASB/IASB lease accounting guidelines will be finalized by the end of 2015 and will probably take effect in 2018 retroactive to January 2016. While it is a couple years out, you absolutely need to start preparing now!

The first step in your preparation is to input your lease data in a well-established leaseadministration software program. When selecting software, you should review the software carefully to ensure that it provides functionality for the current and future lease accounting guidelines, and that it can transfer data to your accounting system to eliminate duplicate data entry.

In addition to testing the software, you should also vet the software company and its key staff members. The people you speak with on the phone or meet in person should have a firm understanding of the current and future FASB lease accounting guidelines. No matter how good the software is, you are going to need training and support when setting up your data and reporting. We also think that the more knowledgeable the company, the easier the software will be to use.

We are obviously biased, but we are confident that ProLease is the best solution and leading provider when it comes to automating your lease accounting in accordance with FASB’s current straight line rent calculations and future capitalization guidelines. We have put in the hard work for thousands of hours over five years, and ProLease is now ready!

Contact us now to talk shop and set up a meeting.



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8. ABOUT USProLease is the leading provider of Lease Administration software. Our software was first released in 1999 and we now have 600+ customers using ProLease today including 3M, Armani, Maersk, PricewaterhouseCoopers, Papyrus and State of Ohio. Our customer base crosses many segments including Corporate, Retail, Healthcare, Government, Non-Profit and Education.

ProLease is a 100% web-based SaaS solution that includes key Lease Administration features such as critical date management, rent payments, document management, lease terms & conditions, dashboards, location mapping and much more. ProLease also has extensive Lease Accounting features that comply with the current FASB 13 and new proposed guidelines for capitalizing leases.

ProCalc Lease Analysis is a “sister” product of ProLease. ProCalc was developed by Alan Bushell and first released in 1992. Since then, it has become the industry standard lease analysis software program, currently used by thousands of commercial real estate professionals allowing users to analyze and compare leases from the tenant, landlord, sub-lessor’s or purchaser’s perspective.

Like ProLease, ProCalc also includes the ability to capitalize leases based on the new FASB Lease Accounting standards. ProCalc also does Pre Tax Cash Flow, Post Tax Cash Flow, GAAP and P&L Analysis.

CONTACT US TODAY TO SCHEDULE A PROLEASE DEMONSTRATION.

877.221.0229 • proleasesoftware.com


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