July 6, 2021
Fitting the Pieces Together: Leases, Accounting and Culture
As the U.S. moves towards business as usual, many business leaders are asking themselves, ‘what is the new normal for my business?’ Large and small organizations proved the success of the work from home business model over the past year out of necessity, and now, many employees prefer a hybrid working arrangement going forward. Where does this trend leave organizations that have significant commercial lease commitments?
Addressing Changing Needs
The first step a leader may take is to survey their employees about their preferred work arrangements and (re)design a workforce strategy that aligns with the organization’s goals and culture. The workforce strategy should ultimately inform future space needs as it is based on a combination of employee feedback and organizational goals. Leaders may also consider using multiple surveys over time to gauge employees’ evolving preferences.
Given significant uncertainties about future space needs, lessees may consider a number of options once they have developed a workforce strategy:
- Stay the course – Hold on to the current space and experiment with small changes over the next several months with furniture and/or technology upgrades
- Downsize now – Reign in rental costs by renegotiating lease terms for a smaller amount of square footage, with rights to expand in the future if desired
- Sublease – Sublease all or a portion of the space to a third party to provide additional financial flexibility in the short term
- Terminate the lease – Continue work from home and pocket the savings from not having a physical location, but beware of termination penalties in lease agreements
Accounting for Lease Modifications
A common pitfall when renegotiating leases is considering the accounting implications after the change is made. Below are accounting impacts to consider in advance of a modification.
The FASB’s new lease standard (Topic 842) is not effective for private organizations until fiscal years beginning after December 15, 2021. Accordingly, accounting guidance discussed herein refers to Topic 840, Leases. The FASB also issued a Q&A guide on how to account for rent deferrals and rent forgiveness as a result of the pandemic.
Renegotiate Lease Terms
If lease terms are significantly renegotiated, the agreement is accounted for as if it is a new lease and evaluation of the lease as capital or operating is made at the new contract inception.
If the original lease is classified as an operating lease, then a sublease is also classified as an operating lease. Account for rental income related to the sublease on a straight-line basis over the lease term. In situations where rental income on the subleased space is less than the cost of the original lease for the square footage subleased, the full estimated loss is recorded at sublease inception.
The most important item when terminating a lease is to review the lease contract for early termination penalties and required notice periods. Penalties and fees are required to be accrued at the time of notice to the landlord in accordance with the provisions of the lease, which can be significantly earlier than when the leased space is vacated.
Financial Statement Disclosures
Material leases and sublease arrangements are required to be disclosed in the notes to an organization’s financial statements. Disclosure requirements include:
- A general description of leasing arrangements
- Rental income/expense for each income statement period presented
- Separate disclosures for minimum rental amounts and sublease amounts
The liability accrued when a lease has been terminated early or impairment charges recognized as a result of a sublease are also required to be disclosed, when applicable.
Business leaders have a lot to consider when planning for the future of work and how much office space will be needed. Understanding the cultural and accounting implications of the various leasing options will better equip decision makers with the tools they need to make informed decisions on significant lease expenses.
Questions on lease accounting? We’re here to help. Contact the Johnson Lambert team.