To err is human. To forgive is against FASB policy. Our last blog addressed how to account for lease amendments that expand the leased premises. In today’s article, we will explain the 6 common lease accounting errors we have found after reviewing thousands of 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:

  • Test 1: We make sure that you are making the correct payments based on the lease documents and,
  • Test 2: 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.

In today’s column, we will show you the top 6 accounting errors we have found after our evaluation of numerous leases. Our discussion will address each of these common errors as follows:

  • First, we will state the error
  • We will explain the correct accounting treatment
  • We will describe the mistake we often see
  • 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,
  • We will demonstrate how LeaseQuery ensures this error does not happen.

Be sure to download a copy of our lease accounting transition guide, so you can ensure you don’t make these same errors yourself.

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Lease Accounting Guide

Error 1 – Problems with lessee accounting for tenant improvement allowances (TIAs):

The correct treatment:

When a lease contains a tenant improvement allowance, the correct entry is to record a liability for the allowance, and record a corresponding receivable upon executing the lease. The liability is straight-lined just like base rent starting from the possession date of the property as a reduction to rent expense, while the receivable is reduced when payment is received from the landlord (or when the landlord pays the contractor directly). Click here to read our article explaining the correct accounting for tenant improvement allowances, which includes a comprehensive example.

The leasehold improvement itself is recorded as CIP during the construction period, and is depreciated over the lesser of the life of the leasehold improvement or the remainder of the lease term, starting from the date the leasehold improvement is placed into service.

This is a very important point: the liability from the tenant improvement allowance is amortized starting from the possession date, while the leasehold improvement itself is amortized starting from the date the improvement is placed into service.

The common error in accounting for TIAs:

When a lessee receives a tenant improvement allowance, a lot of them do one of two things, both of which are wrong: they either do nothing at all, or they reduce the value of the leasehold improvement by the amount of the allowance.

We notice tenants tend to reduce the value of the leasehold improvement in situations when the landlord pays a contractor directly for the improvements rather than paying the tenant.

Why this is wrong and the effect on your financials:

According to GAAP, assets like leasehold improvements should be recorded at historical cost. If the tenant debits the cash received and reduces the value of the leasehold improvement (by crediting it), then the leasehold improvement is understated. If the leasehold improvement is understated, then the associated depreciation expense is understated, which means EBITDA is also understated.

We have heard the argument on more than one occasion that EBITDA would not be affected here, because the additional depreciation expense to be recorded is offset by the reduction in rent expense from the amortization of the liability from the tenant improvement allowance (if recorded accurately). There is a point here, but that point is not valid if the possession date of the property is different from the move in date.

As we stated in the “correct treatment” above, the liability is amortized starting from the possession date, while the leasehold improvement is depreciated starting from the date it is placed in service.  As a result, there could be timing differences in EBITDA.

How LeaseQuery ensures this problem does not occur:

When a tenant improvement allowance is entered into LeaseQuery, the system automatically records a liability and amortizes said liability as a reduction to rent expense over the lease term. When our accountants reconcile your balances in your deferred rent account to the balances per LeaseQuery, (which they do for every client), they will immediately identify the error in your books and give you the correct adjusting entries.

Error 2 – Problems in accounting for TIAs when a lease is renewed or modified

The correct treatment:

When a lease is renewed or modified prior to the end of the initial lease term, then any unamortized tenant improvement allowance under the prior lease should be included in the calculation of straight-line rent expense for the new lease term. Basically, the amortization of the TIA (as described in the Error 1 above) should begin again as of the date of the renewal or modification, over the new term of the renewed or modified lease. Click here to read our article explaining accounting for tenant improvement allowances.

The mistake we often see:

This is one area where we see the most errors. What we often see is companies simply doing nothing at all. This is not correct under GAAP.

Why this is wrong and the effect on your financials:

When companies do not make any changes to the TIA amortization schedules when a lease is renewed or modified, then rent expense is understated in some years and overstated in others. This has the reverse effect on EBITDA; it will be overstated in the years when rent expense is understated and vice versa.

How LeaseQuery software ensures this error does not happen:

When a lease with a TIA is renewed or modified in LeaseQuery prior to the lease term, the system automatically adjusts the amortization schedule starting from the renewal or modification date over the new lease term.

LeaseQuery indicates the lease has been renewed by highlighting the month of the renewal or modification in red, and includes the adjustment in the monthly journal entries it provides. See screenshot below.

TIA Modification

Error 3: Issues when accounting for prior deferred rent when a lease is renewed or modified:

The correct treatment:

Similar to tenant improvement allowances, when a lease is renewed or modified prior to the end of the initial lease term, then any deferred rent under the prior lease should be included in the calculation of straight-line rent expense for the new lease term. Click here to read our article explaining accounting for leases when a lease is modified.

The common error in accounting for deferred rent:

We often find that some companies make no adjustments to the deferred rent recorded from the prior lease. They just leave the liability on their books. The liability just sits on the balance sheet and keeps increasing as leases get renewed or modified.

Why this is wrong and the effect on your financials

This is one error that you do not want to make, because the effect is all bad. First of all, it increases rent expense on your financials because the expense is not reduced by the adjustment for deferred rent from the prior lease. This increase in rent expense and, in turn, reduces EBITDA.

Additionally, your liabilities are overstated because the deferred rent from the prior lease is not being amortized over the new lease. This exact situation caused an adjustment of $500,000 to one of our clients. It was a good thing we discovered it before their auditors did.

The way LeaseQuery ensures this error does not happen:

When a lease is modified or renewed in LeaseQuery prior to the lease term, the system automatically adjusts the deferred rent from the renewal or modification date over the new lease term.

LeaseQuery indicates the lease has been renewed or modified by highlighting the month of the renewal or modification in red, and includes the adjustment to deferred rent in the monthly journal entries it provides. See screenshot below.

Base Rent Modification

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Capital vs. Operating Lease Test

Error 4: Incorrectly determining the lease start date

The 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? 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 on how to know when a lease starts.

The 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:

  • Effect on expense: Rent expense is understated in the early part of the lease, and overstated in subsequent periods.
  • 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:

Possession Date

Error 5: Accounting for removal expenses

The 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.

Asset Retirement Obligation

Error 6: Incorrect accounting for termination options

The 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’s lease accounting software, 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.

Lease Termination Option

In conclusion

There you have it. We hope you enjoyed our blog on the top six lease accounting errors we find companies make and the solutions to these problems. 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 info@leasequery.com.

We write detailed blogs like this to demonstrate that our experts at LeaseQuery are not just real estate professionals, but also lease accounting experts. There is 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 accounting and management software reflects our expertise.

At LeaseQuery, we do not simply provide software. We provide peace of mind. With our solution, you can rest easy knowing that not only are your lease payments accurate, but your lease accounting is appropriate. And if it isn’t, we’ll be the ones to let you know, not your auditors. 

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