A New Accounting Era and Implications for CRE

November 10, 2016
Written by: Sara Farina, CREW Chicago

Recently, new standards for revenue recognition and lease accounting have been finalized that have far-reaching implications for the commercial real estate industry. It is anticipated that negotiations of contracts and agreements and key financial metrics will be effected. Early communication with investors, lenders, and other key stakeholders is key to successful implementation.

Revenue Recognition

The new principles-based process for recognizing revenue is in contrast to the current rules-based, industry-focused approach. Lease revenue is excluded from the scope of this guidance; however, non-lease components included in rental agreements, such as maintenance or other services, are included.

The new approach requires a five-step analysis:

1. Contracts entered into around the same time with the same commercial objective are accounted for as one contract. Modifications or amendments may need to be accounted for prospectively or as a cumulative catch-up.

2. Certain performance obligations are simple to identify, while some contracts contain multiple components that might represent separate performance obligations. Some common examples include management agreements covering multiple services or construction contracts spanning the design phase through construction.

3. Determining the transaction price of the contract may be more difficult if the agreement contains:

  • Variable consideration, such as performance bonuses, unpriced change orders, or incentive asset or property management fees
  • Significant financing components – the time value of money is considered if payment is significantly before or after services are provided (such as with a deferred developer fee)
  • Noncash consideration, including ownership or profits interests

4. The transaction price is allocated to each separate performance obligation. Where multiple performance obligations exist, a standalone price is assigned to each performance obligation, and the transaction price is allocated proportionately to each.

5. Revenue is recognized at a point in time (upon completion of the performance obligation) or over time, based on contract provisions. The pattern of revenue recognition should best depict the performance pattern.

To illustrate, consider a development agreement, in which the developer is responsible for overseeing pre-construction activities, development, and lease-up of a project, with a portion of the total fee assigned to each of these phases. Under the existing guidance, the fee for each phase is recognized when each phase is complete. Under the new guidance, each of the services must be analyzed to determine if it is distinct (whether the standalone service provides a benefit to the customer and whether the service is distinct in the context of the contract). These services will likely not be considered distinct and therefore, the transaction price will be allocated to a single performance obligation. The timing of revenue recognition will be the main difference under the new guidance – assuming the contract qualifies for recognition over time, revenue will be recognized using an input or output method in a manner that best represents the delivery of service over the life of the contract (resembling today’s percentage-of-completion accounting), which may not line up with the fee assigned to each phase in the contract.

Lease Accounting 

The most significant change for lease accounting is the requirement for lessees to report all lease obligations on their balance sheet, with few exceptions. Historically, leases have been classified as capital leases or operating leases, with only capital leases recorded on the balance sheet. Under the new standard, there continues to be two types of leases: finance (similar to capital leases) and operating leases. The criteria for differentiating between the two types of leases is similar to the current guidance, and it is expected that the classification for most leases will not change.

For lessees, a liability will be recorded for future lease payments, along with an asset representing its exclusive right to use the underlying leased asset. Both types of leases will be recorded on the balance sheet. However, the pattern of expense recognition differs. For financing leases, this will generally result in higher amounts of lease expense early in the life of the lease, and lower lease expense in later years. Operating lease expense is recorded straight-line over the term of the lease as a component of rent expense.

For example, for an office lease that qualifies as an operating lease rental expense under both today’s guidance and the new lease standards is recognized on a straight-line basis over the life of the lease. However, under today’s guidance, there is no accounting entry made upon commencement of the lease; under the new guidance, the tenant will record a liability for the future lease payments and a right-of-use asset upon commencement of the lease. As the lease is paid monthly, the entity will record an entry to record rent expense on a straight-line basis, a reduction to the lease liability based on the payment amortization schedule, and accumulated amortization of the right-of-use asset as the balancing figure.

The pending guidance contains an exception for short-term leases (with a lease term of 12 months or less, including renewal periods), which will be accounted for similar to operating leases under current U.S. GAAP.

Under the new standard, there will be fewer changes for lessors – the most significant provision is that lessors are required to assess the collectability of lease payments.

Implementation Timeline 

The revenue recognition standard is effective in 2018 for public companies and 2019 for private companies; while the lease accounting standard goes into effect one year later. As many contracts cover periods longer than the implementation window, entities should begin to plan for the effects of the new standard now.

Organizations should take action now to: 

  • Understand the guidance — Accounting and finance staff should develop a thorough understanding of the key principles in the new standards. Individuals negotiating contracts and lease agreements, or making lease vs. buy decisions, need to understand the potential effects of the new standards when negotiating new agreements or renewals of existing agreements.
  • Review existing contracts – Long-term contracts that will exist upon implementation should be reviewed to quantify the effects of the new standards.
  • Consider information systems and internal controls — More information is required in order to recognize agreements and comply with financial statement disclosure requirements of the new standards. Information systems must be evaluated to determine whether they can provide the necessary data, and related internal controls may also require modification.

To learn more, visit plantemoran.com or contact our industry specialists:
Carole McNees
(269) 567-4592
Sara Farina
(847) 628-8786

Sara FarinaSara Farina is an assurance manager with Plante Moran, specializing in the real estate, construction, and related service industries. She has experience with real estate developers; property and asset management companies; institutional investment funds and REITs; hospitality and other rental real estate portfolios (commercial, multi-family, office, student housing) and homebuilders providing tax and audit services as well as consulting on a variety of matters.