Real Estate Portfolio Management / Lease Administration / Lease Portfolio / Extension for Lease Accounting

Concept: Finance Leases and Operating Leases

Under the FASB ASC 842 and IASB IFRS 16 standards, leases classify as either:

finance
operating

The total cash outflow for finance and operating leases are identical. However, under FASB 842 and IFRS 16 guidance, expense recognition for finance leases is front-loaded to reflect the declining interest expense over the term of the lease.

Finance Leases

Finance leases generally apply to something other than real property, such as tangible personal property (vehicles, machinery, air craft, and other equipment). An arrangement is a finance lease if any of the following conditions exist:

Title transfer is automatic at the end of the lease.
Purchase of the asset is considered a reasonably certain to be exercised.
The lease term is for a major portion of the asset’s economic life. (Note: This criteria does not need to be considered if the lease commencement date falls at or near the end of economic life of the underlying asset.)
The Present Value of Lease Payments -- plus any residual value guaranteed by the lessee that isn’t already reflected in the lease payments -- equals or exceeds substantially all the fair value of the underlying asset.
The underlying asset is of such a specialized nature that only the lessee can use it without major modifications. In other words, the lessor expects to have no alternative use for the leased asset at the end of the lease.

In finance leases, the following is capitalized:

The rent to be capitalized is your minimum fixed rent payments after free rent plus any increases in your rent.
This generally includes base rent plus any fixed increases during the initial and “reasonably certain” renewal terms.

The following expenses do not need to be included:

CAM
operating costs
utility cost
services
For net leases, real estate taxes are not capitalized.
Under a gross lease, the real estate tax amount included in the base rent and does get capitalized.

Operating Leases

All other leases are classified as operating leases, with costs presented as lease expense and recognized on a straight-line basis in the income statement over the lease term. This produces an expense recognition pattern that is similar to operating leases under current U.S. GAAP.

The vast majority of leases for retailers, healthcare providers, and office tenants fall under operating leases.

Note: IASB and FASB differ in this regard. Instead of the dual approach favored by FASB, IASB classifies all leases using as financing.

When to Classify Leases

You typically classify leases to determine if they are operating leases or finance leases in these situations:

Initial Classification of Existing Leases. To get started in complying with IASB and FASB ASC 842 regulations, you will want to revisit each existing lease and determine if it is an operating lease or a finance lease by working through the Wizard.
New Leases. As you develop new leases, you will need to determine if they are operating or financial. As part of developing a new lease, you can work through the Wizard and classify the new lease.
Changed Lease Circumstances. Once you classify a lease, you may find that the situation changes so that you need to verify that the lease is still operating or finance. For example, suppose you used the Wizard six months ago to classify a lease. However, your company has decided to exercise an option to expand the leased space. This change affects your financial situation and could result in a new classification. See Re-evaluating a Classified Lease.