Increased Clarity in Accounting for Operating Leases
Industry Practices Meet GAAP

By James M. Fornaro and Rita J. Buttermilch

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DECEMBER 2006 - In a February 7, 2005, SEC staff letter to the AICPA’s Center for Public Company Audit Firms (CPCAF), then–SEC Chief Accountant Donald Nicolaisen provided clarity on the application of three key issues for lessees:

  • The proper amortization period for leasehold improvements;
  • Accounting for rent holidays; and
  • The treatment of construction incentives received from landlords.

The resulting wave of restatements highlighted the diversity in long-standing industry practices and the misapplication of existing GAAP in these areas. Management at many companies was apparently caught off guard by the SEC’s positions. When announcing restatements, companies often referred to prior industry accounting practices that they believed to be acceptable; many stressed the “non-cash impact” of their restatements. Others reminded investors of the “clean” opinions received from their external auditors (predominantly Big Four firms) during the years in which these accounting practices were in place. Although the restatements were concentrated in the retail and restaurant industries due to the considerable number of real estate leases typical in these businesses, certain underlying issues apply to all operating lease arrangements.

Issue 1: Amortization of Leasehold Improvements

Leasehold improvements placed in service (or contemplated) at or near the beginning of the lease term are generally amortized on a straight-line basis over the shorter of the estimated useful life of the assets or the lease term. Determining the lease term for this purpose often requires judgment to ascertain whether to include periods covered by renewal options. Paragraph 22(a) of SFAS 98, Accounting for Leases, defines the lease term as the fixed noncancelable term plus periods covered by renewals or extensions, depending upon the facts and circumstances surrounding the agreement. [SFAS 98 amended the definition of “lease term” in paragraph 5(f) of SFAS 13, Accounting for Leases, November 1976, particularly with respect to: 1) the treatment of renewal periods where the lessee has provided a loan to the lessor, and 2) the definition of “penalty.”] In general, option periods are included in those cases where, at the inception of the lease, a renewal appears to be “reasonably assured.” In arriving at this conclusion, management must carefully evaluate whether a failure to renew the lease imposes a significant “penalty” on the lessee such that renewal is deemed to be reasonably assured. Exhibit 1 contains a detailed discussion of criteria that practitioners must use to evaluate the lease term and factors to consider when assessing the impact of direct or indirect penalty provisions.

The theoretical and practical considerations concerning the amortization of leaseholds are well documented in the accounting literature. Essentially, the SEC staff reaffirmed existing GAAP, particularly with respect to treatment of renewal periods. Many restatements have resulted from cases where companies amortized leasehold improvements over extended terms that included available renewal options, whether exercise was reasonably assured or not. Accordingly, the extended terms lowered the amortization expense recognized and overstated net income. Exhibit 2 illustrates the considerations and proper amortization period for leasehold improvements, as well as the financial statement impact of common errors.

As a follow-up, FASB Emerging Issues Task Force (EITF) Issue 05-6, Determining the Amortization Period for Leasehold Improvements Purchased after Lease Inception or Acquired in a Business Combination, was issued to address the amortization of leasehold improvements acquired “significantly after and not contemplated at or near the beginning of the initial lease term” or assumed in a business combination. These “subsequently acquired” leasehold improvements should be amortized over the shorter of their estimated useful life or the remaining lease term (reflecting renewal periods that are reasonably assured at the time of purchase or acquisition). EITF Issue 05-6 is applicable to improvements acquired in periods beginning after June 29, 2005. It does not, however, apply to preexisting leasehold improvements, and it may not be used as a basis to reevaluate the amortization periods of those assets.

Issue 2: Accounting for Rent Expense under Operating Leases

It is common for a landlord to provide a tenant with a rent-free period (or holiday) at the initial portion of the lease term. Such provisions are viewed as incentives for the lessee to sign the lease and typically range in length from a few months to one year. Rent holidays permit the lessee to have access to the property to complete the build-out or preparation of the structure while alleviating the burden of rent payments during this timeframe. Other lease arrangements could provide for lower rent payments during the early portions of the lease or contain scheduled increases to account for expected inflation.

FASB Technical Bulletin (FTB) 85-3, Accounting for Operating Leases with Scheduled Rent Increases, in conjunction with the response to Question 1 of FTB 88-1, Issues Relating to Accounting for Leases, stipulate that rent expense for operating leases with rent-free periods or scheduled increases must be accounted for on a straight-line basis over the lease term, including the related holiday period, unless another systematic and rational method is more representative of the lessee’s pattern of use over time. This treatment assumes that the lessee takes possession of or controls the property at the inception of the lease. The SEC staff letter reaffirmed existing GAAP and emphasized the inclusion of the rent holiday within the lease term.

A large number of the restatements during 2005 were driven by prior practices where companies neglected to accrue rent expense during the period of the rent holiday. For instance, Ruby Tuesday, Inc., reported in a press release (April 11, 2005) that its restatement was due in part to the “computation of straight line rent at the earlier of the commencement of the lease payments or when the leased site opened.” Similarly, Ann Taylor Stores Corporation reported (March 17, 2005) that it “had previously recorded straight-line rent expense beginning on the store opening date, as the Company believed that ‘possession’ under FTB No. 88-1 occurred on the date it took physical control of the space through occupancy, without considering the construction build-out period.” In such cases, corrections would serve to increase rent expense recognized during prior rent holidays and decrease rent expense recognized during subsequent periods of the lease.

Consistency is essential when using the lease term in related facets of lease accounting. More specifically, a lessee should use the same lease term to determine: 1) the proper classification as either a capital or operating lease, 2) the appropriate period for amortizing leaseholds, and 3) the proper term over which to recognize straight-line rent. Many restatements revealed inconsistent treatment, whereby the company used a longer lease term (including renewals) to amortize leasehold improvements but used the shorter initial term to recognize rent expense.

Issue 3: Accounting by Lessees for Incentives Received in an Operating Lease

A landlord may provide a tenant with an incentive to sign a particular lease arrangement. Incentives can include a direct cash payment, payment of expenses on behalf of the lessee (e.g., moving expenses), or a reimbursement of costs related to leasehold improvements. Question 2 of FTB 88-1 and paragraph 15 of SFAS 13 require that a payment made by a landlord to or on behalf of a lessee represents an incentive that must be reported by the lessee as a liability (deferred rent) and as a reduction in rent expense on a straight-line basis over the lease term. This treatment considers the incentive to be an inseparable element of the overall agreement that should be recognized along with the other lease provisions.

Diversity in practice had developed with respect to the accounting by lessees for construction-related incentives. When announcing restatements, many companies disclosed their previous practice of netting the cash received against the cost of the associated leasehold improvements rather than accounting for the reimbursements as deferred rent. This treatment understated amortization expense and overstated rent expense recognized over the term of the lease. On the statement of cash flows, this practice understated both the net cash outflows from investing activities and net cash inflows from operating activities.

For example, Payless Shoesource, Inc., reported (March 1, 2005) that a portion of its restatement was due to the “practice of netting landlord-provided tenant improvement allowances against [the related] property and equipment” and did not impact earnings. McCormick & Schmick’s Seafood Restaurants, Inc. reported (March 28, 2005) a similar correction, adding that the restatement increased the balances of leasehold improvements and deferred rent liabilities on the balance sheet and that it increased amortization expense and decreased rent expense on the income statement.

In its February 7, 2005, letter, the SEC staff reaffirmed the appropriate accounting treatment for landlord incentives under FTB 88-1, specifically stating that “it is inappropriate to net the deferred rent against the leasehold improvements.” On the statement of cash flows, purchases of leasehold improvements and the amount of the incentive received should be reported “gross” within investing activities and operating activities, respectively. Exhibit 3 illustrates the appropriate accounting by lessees for incentives received from a landlord and the financial statement impact of errors common in practice.

Rental Costs Incurred During Construction

The restatements led to further scrutiny of existing practices pertaining to lessee accounting for ground (land) leases and rental costs incurred during building construction. Diverse accounting practices, coupled with a perceived lack of specific guidance in this area, were analyzed in EITF Issue 05-3, Accounting for Rental Costs Incurred during the Construction Period. Essentially, the EITF examined the long-standing debate:

  • Do these rental costs qualify for capitalization?
  • If so, is capitalization appropriate for ground rentals, building rentals, or both during construction?

Exhibit 4 provides an expanded discussion of the different views on this issue.

The EITF was unable to reach a consensus on the views discussed in Issue 05-3. In October 2005, however, FASB issued formal guidance in FASB Staff Position (FSP) FAS 13-1, Accounting for Rental Costs Incurred during a Construction Period. This FSP concluded that rental costs are incurred for the right to control the use of leased property, and that there is no distinction between the right to use leased property during or after construction. Accordingly, the staff concluded that a lessee may not capitalize rental costs associated with either ground or building operating leases that are incurred during construction. Such costs are expensed currently and are included when determining income from continuing operations. This guidance was applicable to the first reporting period beginning after December 15, 2005, at which point companies would cease rent capitalization for operating leases entered into prior to the effective date of the guidance. Retrospective application in accordance with FASB 154, Accounting Changes and Error Corrections, was permitted but not required. The latter option likely avoided further restatements by many lessees.

Landlord-Funded Improvements: Who Owns the Asset?

FTB 88-1 presumes that leasehold improvements made by a lessee but funded by the landlord (lessor) are incentives and should be recognized as assets by the lessee with a corresponding liability. In its staff letter, the SEC acknowledged that the decision to record the improvements as assets of the lessor or the lessee “may require significant judgment,” but it did not introduce specific criteria. Accordingly, the lack of guidance with respect to these accounting practices has resulted in identical leasehold improvements being recorded as assets by both the lessor and lessee. Whether the assets are recorded by the lessor or lessee (or both) has a number of consequences on the financial information reported by both parties. Exhibit 5 provides an expanded discussion of these issues and related implications.

Enhanced Disclosures

The SEC staff also reminded registrants that clarity is essential when disclosing capital and operating lease information in the Management’s Discussion and Analysis (MD&A) and footnotes to the financial statements. Disclosures should address the following issues:

  • Material lease agreements or arrangements;
  • Major provisions, such as the original lease term, renewal options, rent holidays and escalations, and incentives;
  • Accounting policies for leases, including those related to the major provisions above;
  • Specifics as to the determination of contingent rentals; and
  • Periods used to amortize both initial and subsequently acquired leasehold improvements and their relationship to the initial lease term.


Despite the level of detailed accounting guidance developed over the last 30 years, the interpretation and application of lease accounting remains controversial. This unexpected surge of restatements in the wake of recent SEC guidance highlights the importance that all accountants refresh their understanding of these issues and undertake a review of their accounting policies and practices for leases. It also reinforces the need to regularly review the propriety and application of both new and long-standing accounting practices. Finally, it serves as a sobering reminder of the unintended consequences that can arise when existing accounting policies are deemed appropriate on the basis of “accepted industry practice.”

CPAs should expect further changes and added complexity in the future. Lease accounting and other off–balance sheet arrangements remain high on the agendas of the SEC, FASB, and the International Accounting Standards Board (IASB).

James M. Fornaro, DPS, CMA, CPA, is director of graduate business programs, and Rita J. Buttermilch, CPA, is an associate professor, both at the school of business of the State University of New York–College at Old Westbury, in Old Westbury, N.Y.





















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