Recent Controversies in Accounting for Operating Leases and Leasehold Improvements

By Bruce Branson and Don Pagach

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To date, the restatements have been concentrated in three industries that rely heavily on leased facilities and equipment: restaurants, retail, and cellular telephone towers. The entities involved have ranged from small-capitalization companies like Smith & Wollensky to such large-capitalization companies as Starbucks and Target. The restatements have focused on three areas: the amortization of leasehold improvements, the recognition of rent expense when the lease agreement contains rent holidays, and incentives related to leasehold improvements.

One set of restatements appears to have resulted from companies amortizing leasehold improvements over a period exceeding the lease term of the property containing the leasehold improvements. Consistent with SFAS 13, Accounting for Leases, the Office of the Chief Accountant stressed that companies must amortize leasehold improvements over the shorter of the economic life of the leasehold improvements or the lease term. In cases where the lessee has the right to renew the lease for additional periods (common in many of these arrangements), the lease term for the purpose of calculating amortization of the capitalized cost of the leasehold improvements should be extended only if it is “reasonably assured” that the lessee will renew the lease.

SFAS 98 provides additional guidance for lessees in determining if a renewal is reasonably assured. If the failure to renew would impose a penalty on the lessee, if there are renewal periods prior to a bargain purchase option exercise date, or if the lease renews at the lessor’s discretion, then the lease term should include the renewal periods. An additional case in which the renewal may be reasonably assured involves instances where the lessee, either directly or indirectly, guarantees the lessor’s debt related to the property. In this case, the lease term should include all ordinary renewal periods during the guarantee period.

The second situation cited by the SEC involves operating leases that contain rent holidays (i.e., periods where rent is waived or discounted). Some companies evidently have mistakenly failed to recognize rent expense in periods preceding the commencement date of operations. The SEC has reiterated that recognition of rent expense should begin as soon as the leased property is physically occupied, even if that period includes a build-out phase. Rent expense should be recognized on a straight-line basis over the entire lease term, including periods where no or reduced rent is paid.

The third situation addressed by the SEC involves operating leases where lessees make leasehold improvements to the leased property that are funded, in whole or in part, by landlord incentives or allowances. Many companies have apparently been treating such incentives as a reduction of property, plant, and equipment and as a reduction in capital expenditures reported in the investing section of the cash flow statement. SEC guidelines state that landlord incentives or allowances should be treated as deferred rent and amortized as a reduction of periodic rent expense over the term of the lease. In addition, companies should record a leasehold improvement equal to the cost of the leasehold improvements funded by the incentives or allowances. The cash flow consequences of the incentives will be shown as a reduction of operating expenses in the operating activities section and as an acquisition of leasehold improvements in the investing activities section.

The chief accountant’s letter reiterates that disclosures associated with lease activity must include the following:

• Material lease agreements or arrangements;
• Essential provisions of material leases, including the original term, renewal periods, reasonably assured rent escalations, rent holidays, contingent rent, rent concessions, leasehold improvement incentives, and any unusual provisions or conditions;
• Accounting policies for leases, including the treatment of each of the above components of lease agreements;
• A basis by which contingent rental payments are determined with specificity, not generality; and
• An amortization period of material leasehold improvements made either at the inception of the lease or during the lease term, along with how the amortization period relates to the initial lease term.

Analysis

The chief accountant’s letter clarifies accepted practice regarding the accounting and reporting requirements for operating leases that include leasehold improvements, rent holidays (or, more generally, nonlevel lease payments), and incentives provided to lessees to partially or fully compensate them for leasehold improvements made to leased properties.

The capitalized cost of leasehold improvements must be allocated over the period during which the lessee will benefit; this period is defined as the shorter of the best estimate of the useful life of the improvements or the period over which the lessee will have use of the leased property. Rent holidays do not represent periods in which no rent expense is incurred, regardless of the timing of the rent payments. The estimated sum of rent payments to be made over the life of the lease should be allocated over the entire lease term and recognized as periodic rent expense. An alternative pattern of expense recognition is allowable if it more closely aligns with the time pattern in which the leased property is employed by the lessee.

Incentives paid to the lessee as compensation for leasehold improvements made to the lessor’s property should be recognized as deferred rent on the balance sheet and amortized over the lease term as an adjustment to periodic rent expense. The costs expended to make the leasehold improvements should be capitalized in full and amortized in an appropriate fashion as discussed above.