This is the second of a two-part series: 6 Lease Accounting Errors You’re Probably Making (And How to Fix Them). Our previous post addressed the first 3 common accounting errors we have found after reviewing thousands of leases. To summarize, those common errors were:
In today’s article, we will show you the next 3 lease accounting errors (errors 4 to 6) we have found after our evaluation of numerous leases.
One thing that makes LeaseQuery different from other lease management software providers is that we are not just real estate professionals; we are also accountants. Why is that important? Well, when you start using our software, we perform two tests on your leases to ensure the following:
1st Test: We make sure that you are making the correct payments based on the lease documents and,
2nd Test: We make sure that your existing leases are complying with GAAP.
While most of the existing lease software out there can perform the first test, the second assessment is more important because even though the correct payments are being made, the entries being recorded may be incorrect. Only accountants can make that determination.
This discussion will follow the same format utilized in PART 1; we will address each of the common errors in this order:
1) First, we will state the error
2) We will explain the correct accounting treatment
3) We will describe the mistake we often see
4) We will evaluate the effect of the mistake on your financials (how it affects net income, EBITDA, etc; basically we will tell you why it matters) and finally,
5) We will demonstrate how LeaseQuery ensures this error does not happen.
Now that we’ve explained that, let’s delve right in. The fourth type of error we will address is:
4 ) Errors in determining the Lease Start Date
Correct Treatment: When exactly does a lease start? Does a lease start on the execution date or on the commencement date? What about the possession date? Or the date the company opens for business at that location? Ladies and gentlemen, for accounting purposes, a lease “starts” on the date possession is passed from the landlord to the tenant.
On that date, the lessee or tenant should start recording straight-line expense, even if that date is earlier than the “commencement date” specified on the lease. Let me stress this again as it is a very important point. The “commencement date” specified on the lease document has ABSOLUTELY no bearing whatsoever on the lease start date under current (and the new) lease accounting rules. Click here to read our blog titled: Do you know when a lease starts?
Mistake we often see: Most of the time, we see that companies use the opening date as the start date for the lease. These companies incorrectly start recording rent expense on that date. Another common error we see is companies use the rent commencement date as the start date of the lease. Both of these dates are WRONG and are NOT GAAP.
Why this is wrong, and the effect on your financials: Using the opening date or the rent commencement date as the start date of the lease affects your financials as follows:
1) Effect on Expense: Rent expense is understated in the early part of the lease, and overstated in subsequent periods.
2) Effect on EBITDA and Net Income: EBITDA and Net income are overstated in the earlier part of the lease, and understated in subsequent periods.
How LeaseQuery ensures this error does not happen: When onboarding a lease, our software asks you for the following dates: execution date, commencement date and possession date and the rent commencement date. The system does not mark the lease as “complete” until the possession date is entered, and it automatically starts amortizing (straight-lining) the lease based on that date. See the screenshot below:
The fifth common error we find is:
5) Errors in accounting for removal expenses
Correct Treatment: There are scenarios where customers are required to return a leased asset to its initial condition at the end of the lease term. In this scenario, a company enters into an operating lease for a building, constructs leasehold improvements, and determines based on the provisions of the lease that it is legally obligated to remove the leasehold improvements at the end of the lease.
Companies in this situation have an asset retirement obligation (ARO). To account for this scenario under GAAP, the company would record a liability for the cost to remove the leasehold improvements, and increase the asset value of the leasehold improvement by the same amount. Click here to read our blog explaining the correct lease accounting when a tenant must return a leased asset to its initial condition at the end of the lease.
Mistake we often see: When companies construct leasehold improvements that they are legally obligated to remove, they do not anticipate and accrue the removal costs. Rather, they expense those costs when incurred.
Why this is wrong, and the effect on your financials: When companies do not accrue for removal of leasehold improvements, then their assets and liabilities are understated, and their net income and EBITDA is understated in the year of removal, because rather than being accrued throughout the lease term, the company takes the entire hit in the last year.
How LeaseQuery ensures this error does not happen: When onboarding a lease, our software asks the user if there is a removal obligation. If there is, then the software accrues for that removal obligation just like an ARO over the lease term. See screenshot below.
6) Errors in accounting for termination options
Correct Treatment: Some leases have a clause allowing the tenant to terminate the lease for convenience or at will without penalty after a certain date. Under GAAP, operating leases should be amortized over the fixed noncancelable lease term. (Click here to read our blog explaining when to amortize a lease). If a tenant has the option to terminate at will, and if the tenant has no significant economic incentive to continue to utilize the asset after the terminate date, then the noncancelable lease term would exclude the period after the termination date. If the tenant elects to let the terminate option lapse, then that is essentially a renewal, and a new straight-line amortization schedule would be calculated starting from that date. Click here to read our article explaining the accounting for leases with termination at will options, which includes a comprehensive example.
Mistake we often see: Often when we come across leases that have termination at will options, we find that the tenant does not take the termination date into account when determining the lease term.
Why this is wrong, and the effect on your financials: When a lease includes a termination at will which is not considered in determination of the lease term, then rent expense is overstated and the liability on the balance sheet (deferred rent) is also overstated if the lease has escalating rent payments.
How LeaseQuery ensures this error does not happen: When onboarding a lease into LeaseQuery, the system asks you if there is a termination at will option. If there is, then it automatically uses that date as the “accounting lease end date,” and also enters the end date per the lease document as the “contract end date.” The system will then correctly amortize the lease from the possession date through the lease end date. See image below.
There you have it, a detailed blog explaining the top 6 lease accounting errors we find most companies make. Once again, we would like to stress that if you have any questions about lease accounting, you can either leave a comment below at the end of this post, or drop us a note at firstname.lastname@example.org. We write detailed blogs like this to demonstrate that our experts at LeaseQuery are not just real estate professionals, but also lease accounting experts. Trust us, there’s a difference. Our clients have unlimited access to our accounting professionals, and we consult with them on complex lease accounting issues. We understand the challenges faced not just by real estate and equipment leasing professionals, but also the accounting departments supporting both groups. Our lease management software reflects our expertise.
If you liked this post, consider reading the following:
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About LeaseQuery: LeaseQuery is lease management software that helps companies manage their leases. Rather than relying on excel spreadsheets, our clients use LeaseQuery to get alerts for critical dates (renewals, etc.), calculate the straight-line amortization of rent and TI allowances per GAAP, provide the required monthly journal entries (for both capital and operating leases) and provide the commitment disclosure reports required in the notes and the MD&A. Contact us here.