Bill Bosco examines interim rent accounting under ASU 842, including implications for both lessees and lessors. He encourages lessors to become very familiar with the new lessee accounting rules as they will have a large impact on their lessee customers.
Interim rent accounting in practice has been inconsistent and, in some cases erroneous, under current GAAP for both lessees and lessors. That will change in a big way as lessee CFOs and auditors increase their focus on lessee accounting, since all leases must be capitalized. The new rules also provide more explicit definitions of lease payment and lease term for lessees and lessors.
This article will deal with two types of interim rent.
The first involves interim rent charged to lessees when the lessor billing period begins on the first day of the billing period and the asset is delivered on another day. In this scenario, the lessor charges interim rent for the stub period, most often based on a pro rata portion of the normal period’s rent. The pro rata calculation means there is an element of lessor investment amortization besides interest in the interim lease payment. This stub period is part of the lease term under the new rules. The lease term begins when the asset is ready for use and delivered to the control of the lessee, and the interim rent is a lease payment to be capitalized as part of the ROU asset.
The second type is interim rents paid on an asset being constructed (i.e. corporate aircraft and truck chassis being outfitted). In this case, the lessor funds the down payment/progress payments and other asset costs, charging interim rent based on the invested funds either on an interest-only basis (calculated by multiplying a lease implicit rate times the lessor’s cash invested for the interim period — the most common method for this type of interim rent) or on a prorated portion of the normal period’s rent rate. In this case, the interim period and interim rent payments occur before completion of construction and delivery of the asset to the lessee, which is the commencement date/booking date of the lease, so the interim period is not included in the lease term by the new definitions in ASU 842.
Under current practice, since interim rents are unknown when the lease is reviewed for classification, they have often been ignored when classifying a lease. This is more or less an oversight. Often the lessee merely expenses the interim rents as paid. Lessees may not realize the true cost of interim rents as there is less CFO/audit focus on off-balance sheet operating leases than capital leases. Interim rents can be an additional profit point for lessors that lessees may not be aware of, especially if the interim rent is not interest-only rent.
Under the new rules the definition of lease payments includes fixed contractual rents (including interim rents), variable rents based on a rate or index (using the spot rate to calculate the payments), renewal rents where the lessee has an economic incentive to exercise (meant to have the same meaning as bargain/compelling renewals under current GAAP), termination penalties (if the lessee assumes it will terminate the lease), probable payments under lessee residual guarantees and in-substance fixed lease payments (payments that may appear to contain variability but are unavoidable, such as a restocking fee payable if the lessee returns the asset at expiry — the lessee cannot avoid that payment without buying the asset).
The lessee’s CFO has the responsibility of capitalizing and classifying all leases using the new definition of lease payments and the lease term. There still is a significant lessee benefit to operating lease classification since the liability is not debt, which reduces debt-limit covenant pressures and results in a straight-line lease cost causing a reduced negative impact to ROA measures. Lessors should be sure the lease proposed will be classified as an operating lease. This will be more difficult under the new rules, so lessors will have to think of new structuring ideas and product twists. From my experience, many small-ticket PC and office equipment leases may not qualify for operating lease treatment when the interim rent and or restocking fees are included in the classification test. I ran a test using a 36-month PC lease with a PV of rents of 89.9% of cost and the addition of a 15-day interim rent caused the PV to exceed 90%, which excluded it from the operating lease classification.
Dealing with the practical accounting issues, lessees will pay the interim rent payment and debit the ROU asset account. When the asset is delivered, the lease begins, and they will book the lease.
For those interim rents caused by a stub period before the lessor’s billing cycle begins, the date the asset is delivered and the lessee controls its use is the commencement date of the lease (so a 36-month lease with a 15-day interim period has a 36.5-month lease term). There are systems implications to the handling of interim rents. Since the lessee must account for the stub period, a lease term must be able to include a partial period. In an operating lease, the rent expense is recognized on a straight-line basis so the stub period lease cost is for a partial period. If the lease is a finance lease, the stub period lease cost will include straight amortization of the ROU asset for a partial month and a partial month’s interest expense. This certainly complicates the accounting and therefore the accounting system’s development.
For interim rents caused by the asset having a construction period, the commencement date is the date the asset is completed and delivered to the lessee, and the lessee controls its use. The commencement date is the date that the lease term and lease accounting begin, which makes the accounting and systems needs much simpler than the case above as there is no stub period. If the lease is an operating lease, the interim rent is added to the total rents to determine the straight line rent expense recognized. If the lease is a finance lease, the interim rents are an increase in the ROU asset — I would treat it as a sub-account of the ROU asset and amortize it straight line over the lease term, charging amortization expense. The interim rent would not be a part of the calculation to capitalize the lease liability as the payment was received before commencement date and thus is no longer a liability. The capitalized lease liability is the present value of the remaining lease payments using either the rate implicit in the lease if it is determinable (but it rarely is under the ASU 842 definition as it includes the lessors IDC, which a lessee cannot know), or the lessee’s incremental borrowing rate.
Under current practice, some lessors have been taking interim rent into income as received. This is not correct. Interim rent is a lease payment and, for operating leases, it should be included in the straight-line recognition of the lease rent income over the term. For direct finance leases, it should be included in the implicit rate calculation and amortized over the lease term to produce a constant rate of return.
For Finance Leases: When the interim rent is received, the lessor debits cash and credits deferred lease income. When the lease commences, the deferred income would be amortized over the lease term along with the balance of deferred lease income. To accomplish this, recalculate the implicit rate to include the interim rents as a period zero cash flow in the calculation.
For Operating Leases: When the interim rent is received, the lessor debits cash and credits deferred rent income. When the lease commences, the deferred rent is included in the calculation of the straight-line rent income recognized over the lease term as rent income.
Lessors should take care to understand the new rules and their implications completely. There are new definitions and a higher level of focus on lessee accounting, which will most definitely affect lessee customers. Lessors should be adjusting products and training their sales staff. It may seem as if the transition date is far off, but some large companies are adopting ASU 842 early. If this plays out, lessors will have to be ready sooner than they thought.
November 1, 2018
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