Lease Accounting 101
Understanding Finance vs. Operating Leases
Classifying leases as finance or operating is fundamental to how companies manage leased assets and report them under today’s U.S. GAAP standards. Regardless of whether a company is entering into a traditional lease or a sale-leaseback, understanding the distinctions is essential for accurate financial reporting and decision-making.
What is a finance lease?
Leases are classified as ‘finance’ when they have characteristics that make them similar to financing the purchase of the underlying asset. To qualify as a finance lease, one or more of the following criteria must be met:
- Transfer of Ownership: Ownership transfers to the lessee at the end of the lease
- Lease Purchase Option: The lessee has an option to buy the asset (and likely will)
- Lease Term: The lease term represents most of the asset’s remaining economic life (typically 75% or more)
- Present Value: The present value of the lease payments (and any residual value guarantee) is equal to or exceeds substantially all of the asset’s fair market value (typically 90% or more)
Under a finance lease, the lessee is deemed to have control over the asset. As such, finance leases are accounted for as if the lessee has ownership of the asset. Accordingly, the lessee recognizes the rent expense as a bifurcated expense between interest expense and depreciation on the income statement as well as a right-of-use asset and lease liability on the balance sheet. Given the nature of the arrangement, finance leases require careful consideration due to the impact on said financial statements.
What is an operating lease?
An operating lease is much more like a typical lease arrangement, where the lessor permits the lessee to utilize an asset for a set period of time. Under older accounting standards, these assets and related liabilities were not recorded on balance sheet, but that changed in 2016 with ASC 842, in which lessees are now required to bring operating leases on their balance sheet. Leases are categorized as operating if none of the four criteria for finance leases listed above are met.
With an operating lease, ownership is not transferred at the end of the lease period. This carries with it the risk that when the lease term ends, a company may be asked to leave or offered unfavorable terms to renew the lease. However, this could also be a plus if the company is looking to move locations.
On financial statements, operating leases are accounted for as a right-of-use asset and a lease liability, with all rent expense being recorded as an operating cost.
Special considerations for sale-leasebacks
Sale-leasebacks have an added layer to consider. For the transaction to qualify as a true sale under ASC 842, the sale-leaseback must be classified as an operating lease. If it is classified as a finance lease for any of the reasons above, it is treated as a ‘failed sale.’
When the sale fails, the seller/lessee:
- Does not derecognize the asset on its balance sheet and instead records the proceeds as a loan
- Pays down the loan through lease payments, which are split into principal and interest expense. The interest rate is based on the seller’s incremental borrowing rate
W. P. Carey can help
Understanding the differences between finance and operating leases is crucial for businesses, especially those considering a sale-leaseback. With both lease types now displayed on balance sheet, it’s important for companies to understand the nuances of each so they can best adhere to accounting standards and make well-informed decisions about their lease agreements.
For a deeper breakdown into lease accounting, take a look at Lease Accounting: IFRS vs. US GAAP. In this article, we explore the key differences in lease classification, measurement and presentation under IFRS 16 and ASC 842 and go into more detail on the implications of failed sale accounting for buyers and sellers.
W. P. Carey has more than 50 years of experience executing sale-leasebacks and helping companies structure customized leases that make the most sense for their business. While W. P. Carey can help, lessees should consult their accounting professional to address their specific needs.
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Commercial Lease Types Explained: Find the Best Lease for Your Business
People who are relatively new to leasing commercial real estate often mistakenly think it is similar to a residential lease on a house or apartment. In fact, commercial leases are quite different and often much more complicated. There are different commercial real estate lease types, each of which suits the needs of different businesses and landlords. It's vital to understand what kind of lease you are being offered for your commercial property so you can ensure it’s the right lease for your business. Here are the various lease types and how they work. Gross Lease A gross lease is one where you pay a flat rental fee that includes everything. This means taxes, insurance, utilities and maintenance costs are all included in the lease. You might compare this with the rare residential lease that includes utilities and possibly cable. Gross leases work well if you are renting office space or retail space in a mall. The lease is calculated to include your share of all of the common operating costs of the space. In other words, your rent will include a prorated share of real estate tax, utilities, building insurance and janitorial costs. This allows landlords to avoid having to meter individual spaces. Gross leases are typically calculated by analysis or past data, but you can often negotiate specific terms of the lease. For example, the standard lease on an office building might include your share of janitorial services in common areas and other common area maintenance, but it can be to your benefit to negotiate a lease that also includes janitorial services inside the office. This saves money because you are paying for extra time from a company that is already coming in vs. hiring a new company altogether. Modified Gross Lease This is a lease where you might have negotiated not to pay for certain things, such as electric utility. This is also very common for commercial spaces with multiple tenants. Full-Service Lease This is a lease where you only have to worry about your rent. Everything else is handled by the landlord. This is often a lot more expensive than other lease types, but it can be easier to budget as you don't have to worry about, for example, seasonal increases in utility bills. It is also called a service gross lease. Choosing a gross lease may seem like the simpler option, but you will pay a bigger rent check every month compared to other lease types. You also need to trust that the landlord will keep up their end of the bargain and ensure that everything is paid for, and maintenance gets done when needed. Net Lease A net lease, on the other hand, is one which works from the base assumption that the tenant will be taking on responsibility for some or all of the costs of running and maintaining the building. This is more common with single-tenant buildings such as warehouses or restaurants, although can be executed in multi-tenant buildings as well. A pure net lease makes you responsible for all the costs related to a property. The rent is thus lower, and although you are responsible for other costs you can typically keep operating costs down by exploring sustainable retrofit projects like a solar panel installation if your facility does not already have. One advantage beyond the benefit of a lower base rent of a net lease is that you often have more control over the property and thereby maintain a sense of ownership. You can, for example, freely choose your own utility providers and maintenance workers instead of being stuck with the landlord's preferred vendor. While your operating costs may be less predictable compared to a gross lease, net leases tend to be long-term in nature so the uncertainty of operating costs is offset by the predictability in rental fees. Here are the three major types of net leases: Single-Net Lease: In a single-net lease, the tenant pays property tax and other taxes and rent while the landlord covers everything else. Also called an N lease. Double-Net Lease: In a double-net lease, the tenant pays taxes, rent and property insurance while the landlord covers everything else. Also called an NN lease. Triple-Net Lease: In a triple-net lease, the tenant pays all costs related to property management including taxes, rent, property insurance, maintenance and other costs. Also called an NNN lease. This is the most common type of net lease. Percentage Lease A percentage lease is a lease where instead of paying a fixed rent, you pay your landlord a percentage of your sales. This includes a certain amount of base rent, and also a negotiated break-even point, which might be a fixed amount or the base rent divided by the agreed percentage. Percentage leases can sometimes be beneficial to both parties for retail space, especially in a mall or shopping center. The terms can be net or gross, with the amount of the base rent set according to what the landlord is responsible for in terms of operating costs. Operating versus Capital Lease Most commercial real estate leases are operating leases, meaning you do not get ownership of the property after the lease is done. In many cases you will be able to renew and renegotiate the lease. With a capital lease, the property is treated as a purchase for accounting purposes, and you may gain ownership at the end of the lease. Capital leases have fairly strict requirements and are relatively rare in commercial real estate. They are similar to finance leases, where you automatically gain ownership at the end of the lease term. Ground Lease A ground lease is when you own the building, but another party owns the land it is located on. Ground leases tend to be very long, averaging 50 to 99 years (compared to the 10 to 30 year lease term of net leases and the typically even shorter gross leases). While ground leases can offer you full control over the building, with some limitations, you are adding another stakeholder with other interests and opinions. It can also be harder to get out of a ground lease if you need to relocate your business. So, what is the best type of commercial lease agreement? The answer is that it depends on your business and the kind of space you are leasing. W. P. Carey is a long-term owner of real estate focused on triple-net leases. We primarily own single-tenant industrial properties that tend to be critical to business operations and therefore unlikely to be vacated for many years. This type of lease makes the most sense for these businesses as it gives the tenant full operational control over the property and is most similar to ownership. The added benefit of selling to W. P. Carey is that we are a long-term holder of real estate and do not look to flip our assets. We have a vested interest in maintaining the quality of our portfolio and pride ourselves in serving as a partner to our tenants should you have additional real estate or capital needs past the point of initial sale. That said, with over 50 years of experience providing customized solutions to our sellers, W. P. Carey can work with you on a lease type that is best for you and your business. Want to learn more? Contact & start the conversation with W. P. Carey today!
The CFO's Cheat Sheet
In anticipation of a potential recession, it's more important than ever for CFOs to find ways to free up cash on their balance sheets. Having a strong balance sheet ensures your company will remain financially stable in any economic condition and allows you to take advantage of growth opportunities that may arise. While there are a number of different strategies CFOs can leverage to improve balance sheet health, here are a few of the most effective. Invest in higher-performing segments of the business—and ditch those that aren't performing By evaluating returns—or losses—from facilities, equipment, plants and other long-term hard assets, CFOs can identify low-performing assets. Selling or repurposing these assets allows CFOs to deploy cash to higher value activities and growth initiatives while delaying capital expenditure, thus improving a company's net income. Review Accounts Receivables and Payables Weak collection policies, slow invoicing, inefficient payment processes and out-of-market terms slows the cash-conversion cycle and ties up cash. CFOs can unlock extra cash for investment, dividend payments, debt payments and mergers and acquisitions by identifying gaps in receivables and payables from the prior year. Usually, a thorough analysis can reveal process gaps, unfavorable and unnecessary terms with customers and vendors and other near-term opportunities, which can help streamline and unlock working capital. Get Smart Credit Support CFOs who use letters of credit, surety bonds and cash collateral as credit support for regulatory or commercial purposes risk misallocating liquidity. A CFO and other stakeholders working with a legal expert can boost a company's liquidity by evaluating—on a regular basis—whether or not all credit support is still required. Where credit support is still necessary, CFOs should always examine the most capital-efficient way for their companies to offer financial collateral. Reduce the Cash Going Out A cash-flow deficit will lead to the eventual downfall of a business. However, reducing the money going out is an effective way to maintain a positive cash flow and improve the balance sheet. CFOs can optimize cash flow by mapping out best-case, worst-case and likely scenarios. If the company's likely scenario is similar to the worst-case scenario, CFOs must find ways to minimize the cash going out to free up more cash. A good starting point for CFOs is to review every detail of a company's Profit & Loss Report and ask the following questions: Why is the company utilizing cash? Can the company achieve this goal more efficiently and cost-effectively? Should the company stop spending the cash altogether? Is there a better deal from this or another supplier? Build Up Cash Reserve Besides managing the cash going out, CFOs need to monitor the cash held closely. This is the money businesses build up to take advantage of an unexpected opportunity or to use during emergencies. Without sufficient funds in reserve, businesses will always find themselves scrambling to secure financing quickly. The general rule of thumb is, until a company builds up its hold or protective balance, a third should be invested back into the business to boost growth, a third should go back into operations and a third should be held. Cash Flow Projection Negative and positive cash flow swings do not have to find CFOs off-guard. CFOs can perform a cash flow analysis to identify trends of negative and positive cash flow swings in a business. This allows a CFO to predict when a company will have a surplus or deficit of cash which helps in planning for the best time to pay expenses. The best practice here is to match a business's cash outflows to the inflows instead of depending on short-term borrowing to cover gaps. This is because, although short-term borrowing has lower interest rates, it still adds to the overall costs of a business. Leasing Equipment and Devices Leasing equipment, devices, motor vehicles and real estate may seem counterintuitive to someone who is only paying attention to the bottom line. However, leasing allows a company to free up more cash because it entails paying in small increments. An added advantage of leasing is that lease payments are considered business expenses and thus can be deducted from a company's tax obligations. Moreover, some devices and equipment can quickly become outdated, inefficient and incompatible with the latest technology. Constantly upgrading or buying new ones to keep up with technological advancements is very costly. Leasing devices and other equipment is an excellent way to stay up-to-date while freeing up cash to invest in high-value projects. Unlock Illiquid Capital Trapped in Real Estate Through a Sale-leaseback One often underused avenue of unlocking capital for company’s balance sheet is a sale-leaseback (also known as a sale-and-leaseback or leaseback). It is a financial transaction where a company sells its real estate to an investor for cash and then leases it from the buyer. When selecting a buyer, it’s important to find an established real estate investor who will value the property accordingly and will pay the full fair market value. Real estate is an illiquid asset that is a drag on many companies' balance sheets— particularly those not in the business of owning real estate. A sale-leaseback enables a company to sell real estate to an investor-landlord and continue to use the property through a long-term lease. Through a sale-leaseback, CFOs can unlock illiquid capital and reinvest it into growth initiatives or other high-performing areas of the business. If you’re considering a sale-leaseback, check out “Is a Sale-Leaseback Right for Your Business?” Conclusion Having a strong balance sheet is critical for several reasons. Ensuring a company has strong cash flows helps support ongoing operations through any economic cycle and gives the company the ability to take advantage of growth opportunities. If CFOs are interested in pursuing a sale-leaseback as part of their balance sheet strategy, working with an experienced partner like W. P. Carey can ensure the company is maximizing the value of their real estate and unlocking 100% of an otherwise illiquid asset. For a real-world example of how a sale-leaseback can be used to support a company’s balance sheet and growth, view a case study here. Think a sale-leaseback might be a good fit for you? Get in touch today!
Top 3 Financial Strategies for CFOs to Fund Business
Inflation is currently at 8.2% year to year, way above its 2% benchmark. The Fed has increased interest rates three times in a row to try and keep inflation under control, with promises of further interest rate increases to achieve a terminal target of 4.6% in 2023. Higher interest rates have a direct impact on your funding efforts. Increasing rates reduces spending power, causing stock prices to fall almost immediately while increasing the cost of debt. In an ideal world, you would be able to make all the money you need by simply selling goods and services. But the general business strategy is that you need money to make money, which means getting external funding. Finding affordable funding can be a difficult strategic decision for any chief financial officer, especially in the current economy. While equity and debt are major sources of business funding, a sale-leaseback is a good option to consider when you are looking for more affordable financing. Here's a closer look at the pros and cons of debt, equity and sale-leasebacks and why a sale-leaseback may be the best financial strategy for your company in the prevailing economy. Public markets capital raise (equity and debt) One of the ways to raise funds is through debt or equity financing. With debt financing, you issue corporate bonds to the public and pay back the full loan amount plus interest upon maturity of the bond. Corporate bonds attract a higher rate of interest than government bonds because of the perceived higher risk, meaning more costs for you. Equity financing involves selling company shares in the stock market and paying the equity holders a dividend or return should the stock value appreciate. Your obligation to pay earnings to equity holders will depend on the types of shares held. Preferential shareholders receive payments first, while common shareholders get paid after creditors and preferred shareholders. Pros You can raise large sums of money from the public. Interest rates paid are typically lower than bank interest rates. Stock issuance does not require you to pay investors. Payments are based on business performance. Interest on debt financing is tax deductible but there are limitations. Cons The current rising interest rates have caused a general fall in share prices, making equity funding a less ideal way to raise funds. Equity raises dilute stocks since each shareholder owns a small piece of the company. The current economic slowdown makes it harder for businesses to get debt financing. Even when you do, the cost of debt is high and you have to pay lenders regardless of the performance of your business. While you do not have to repay equity, shareholders are entitled to a share of a company's earnings. Dividends paid to investors are not tax-deductible like in debt financing. Investors are a huge part of your company's decision-making. Outside funding can cause tension between your company and investors. Loans A loan can be handy when you need working capital or funds for short-term needs, especially when you are running a high-growth business. In this case, you can borrow money privately, for instance, from a bank. Pros The market has a variety of lenders you can chose from. Interest on debt financing is tax-deductible but there are limitations. Private borrowing can help boost your credit score. Cons Interest rates are rising, making it difficult to find a good rate for your loan. Banks are increasing their lending restrictions. Refinancing a loan can be more expensive as interest rates keep rising. You have to repay lenders even when your company isn't doing well, which can result in bankruptcy or litigation. Debt and equity finance can be risky. Failure to repay public debt or a loan can result in default or bankruptcy which affects corporate credit scores. Equity financing also has its downsides since you miss out on tax benefits and also risk ownership dissolution since new and old investors expect a share of corporate profits. These cons are a great reason why sale-leasebacks are the more attractive option. Sale-leaseback What is a sale-leaseback? A sale-leaseback, also called a sale-and-leaseback, is an agreement between you and an investor where you sell your real estate for 100% of the value of your property and simultaneously enter into a long-term lease for the same property. A sale-leaseback is not classified as debt or equity but as a hybrid debt product. You can access much-needed capital when you sell your real estate within a sale-leaseback agreement without increasing your debt. A sale-leaseback is the best financing option when you have cash invested in your property or land that you could use to better your cash flow or invest in profitable business projects while maintaining operational control of your asset. A sale-leaseback is one of the best financial strategies for CFOs to fund business as it can improve your financial statements. By enabling you to pay down debt and improve cash flows, sale-leasebacks can improve your company’s balance sheet health. Pros Rental payments from a sale-leaseback qualify for tax deductions. You transfer the volatility risks of owning your real estate to the new owner. The agreement involves a long-term lease at your agreed-upon rental rate, providing stability for the future. Sale-leasebacks generally fetch a lower rate in the current environment when compared to debt financing. You get a long-term capital partner who can fund future expansions, renovations and build-to-suits to help grow your business. If you're not in the business of owning real estate, you can unlock 100% of cash in illiquid real estate at market value and reinvest it in profitable areas of business. You can maintain operational control of your real estate after selling it. A sale-leaseback gives you immediate access to capital to reinvest in your core business operations compared to a loan or equity financing which may take some time. Cons If you've never done a sale-leaseback, you may not even know how to start. W. P. Carey can help. We specialize in acquiring real estate and creating custom sale-leaseback structures to meet your unique needs. You need to own your real estate assets to pursue a sale-leaseback, so this type of financing may not be possible for some businesses. We're here to help with your sale-leaseback needs If you are looking for more cash flow for your business, you could take the traditional route with capital raising or a loan or go for a sale-leaseback. A sale-leaseback may be the more attractive strategy to secure the financial flexibility you need to pursue your strategic business goals. Learn more about sale-leasebacks and how other companies use them as a powerful capital solution to fund business growth. Think a sale-leaseback is right for your company? Contact our team!