Are Generally Accepted Accounting Principles Important to You?

Sarbanes Oxley and Real Estate Leases

What is GAAP rent and how does it impact SOX?

In essence, GAAP (Generally Accepted Accounting Principals) rent is an averaging of the rent over the term taking into account rent abatement and fixed/known rent increases. The rent cost calculated based on GAAP is then charged/booked to the Income Statement / Profit & Loss (P&L) statement. The P&L statement is what is reported to the Securities and Exchange Commission (SEC) and is used for tax purposes. In many corporations, the GAAP rent is also the cost that is charged to the real estate department's or end-user's budget.

See examples of LseMod - Sarbanes Oxley products.

CPI & GAAP — a CPI GAAP analysis

What happens if there is free rent and rent increases are based on the Consumer Price Index (CPI), a "CPI GAAP analysis"? Since increases are not a "known" value, it is difficult to apply GAAP to a lease with CPI increases.

However, what happens if there is a 20 year term, the first 18 months of rent is free, and the rent increases by the CPI starting in year 11? A solution is to adjust the P&L rent for the Base Rent (i.e., the initial rent without any increases) and straight line that cost to the P&L. The CPI increases can then be added as a separate line item starting in year 11. For analysis purposes, we call this a CPI GAAP analysis.

What are some other GAAP requirements?

The estimated costs for Restoration, also known as Make-Good and Dilapidations in the UK, need to be charged to the P&L. The cost is estimated and then amortized over the term.

Landlord inducements, including a landlord's construction allowance, needs to be accounted for differently. The logic is the inducement is a loan from the landlord and included in the base rent. Consequently, GAAP requires the tenant capitalize the cost without the landlord allowance deduction and depreciate this total cost. The landlord's allowance is treated as a credit to capital cost in terms of Cash Flow and on the P&L it is treated as a net rent credit spread over the balance of the term. In the event there is another inducement besides a construction allowance at a later date in the term, that cost is again treated as a credit to net rent over the remaining balance of the term.

LseMod Pro includes the OPTION to treat all or part of these requirements using, or not using GAAP.

Are Subleases impacted by SOX?

GAAP also dictates how the costs associated with subleases need to be calculated to be in compliance with SOX. Start by determining the net present value of all rental costs including write-offs of depreciation and subleasing costs, offset by the sublease income, the NPV (net present value) write-off. The Income Statement (Profit & Loss statement) is then charged the NPV write-off and it is charged an interest expense based on a declining balance of the NPV write-off, the accretion interest expense. The declining balance is determined by taking the net monthly costs (including sublease income) and the interest expense and deducting that cost from the NPV write-off.

See examples of LseMod - Sarbanes Oxley products.

Capital vs. Operating Leases

Four tests required to determine if a lease is a Capital instead of an Operating Lease are as follows:

Test 1 - Does Title Revert to Tenant
Test 2 - Is there a Bargain Purchase Option
Test 3 - Is the lease greater than 75% of Remaining Life of the building
Test 4 - Is the Present Value of Rent greater than 90% of the Fair Market Value of the building?

LseMod Pro includes these four tests.

How does LseMod help with SOX rent compliance?

Because LseMod Pro does GAAP rent analysis, CPI GAAP analysis, GAAP sublease analysis, and provides detailed reports, it meets the requirements of Sarbanes Oxley. Additionally, users can evaluate different scenarios that may happen partially through a lease term by adjusting the rent to a predetermined GAAP value. Note: LseMod has developed a number of software programs for real estate financial analysis and also has programs that evaluate leases based on just Cash Flow and do not include the corporate P&L (the part requiring GAAP) and taxes.

LseMod - Sarbanes Oxley Products

Example of Sarbanes Oxley lease analysis

Example of GAAP sublease analysis

Example of GAAP Sale Leaseback analysis

SOX - 5 Rules You Need to Know!

SOX Compliance - It's impact on Site Selection Financial Analysis

Presentation made at the SIOR 2006 Conference by Jim Duport. Starting with types of analyses (e.g Cash Flow and Accrual), then the relationship between SOX (Sarbanes Oxley) and GAAP (Generally Accepted Accounting Principals), the presentation talks about and shows an example of how doing an analysis in GAAP, as required by SOX, differs from a Cash Flow analysis and why it is important. Rules covered include straight-lining of rent, accounting for a landlord's tenant improvement allowance, restoration, subleasing, and when "rent" starts.

Download this SOX Compliance presentation.

Related information

SEC position paper

SEC requires restating financial results

Disclaimer - The statements herein represent our interpretation of GAAP and FASB. They are NOT intended to replace information received from tax accounting professionals.

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