Final Assessment: Lease Restructurings, Audit Rights, and FASB Lease Accounting Changes

FASB reporting changes will mandate a commercial lease to be recognized as both an asset and liability on a balance sheet, rather than being merely written off as an expense on a company’s profit and loss statement.

Pre-FASB changes, financial statements were accurately portraying the health of a company’s true financial picture by not including commercial space leases on a company’s balance sheet.

In order to verify the additional rent being charged by the landlord, it is in the tenant’s best interest to audit and verify the accuracy of a landlord’s books, records and/or authoritative documentation in support of the additional rent items charged by the landlord.

It is unnecessary for landlords to put limitations on a tenant’s ability to audit its books and records within a commercial lease.

In regards to a tenant’s audit rights, it is in the landlord’s interest to provide language that only allows tenant to perform an audit of landlord’s books and records during certain specified times of the day and/or the month (e.g., only during the hours of 10 AM to 4 PM on Monday through Friday on the 10^th through the 25^th day of the month and not during the period January 15^th through April 15^th).

Tenant advocates should negotiate for language in the lease stating that, in the event tenant fails to send landlord tenant’s audit notice within 30 days following tenant’s receipt of the end of year statement, such end of year statement shall be conclusive and binding upon tenant.

Tenant advocates should negotiate for language in the lease reflecting that a landlord’s failure to claim any payments of rents, percentage rents, or other rents (including rents with respect to operating expenses and taxes) or payables within two (2) years after the date any such rents were determinable shall constitute landlord’s waiver of such payment.

If a tenant’s audit alleges that an error was made by landlord in their calculation of additional rent, landlords should accept tenant’s findings without verifying tenant’s audit for accuracy.

A tenant advocate should push for language stating that if a significant discrepancy is found in the landlord’s books relating to an additional rent payment, the landlord should be required to pay for the tenant’s audit.

In the event a retail landlord is receiving a share of its tenant’s profits or gross revenue above a specific “breakpoint” in revenue as part of the additional rent to be paid to landlord, the landlord should secure the right to audit all of tenant’s books and records.

In a retail lease where the landlord is receiving a share of its tenant’s profits or gross revenue, the landlord should provide in the lease that if a landlord audit shows the tenant understated their gross sales for the previous audit period, tenant shall immediately pay to the landlord the additional percentage rental due for the period audited.

In a retail lease where the landlord is receiving a share of its tenant’s profits or gross revenue, the tenant should attempt to negotiate for language stating that if a tenant’s audit finds that tenant paid an excess of three percent (3%) or more of additional rent, landlord shall also pay tenant the reasonable cost of such audit and examination.

There is no situation in commercial leasing where a landlord should negotiate to have the right to audit tenant’s books and records.

In a retail lease where the landlord is receiving a share of its tenant’s profits or gross revenue and the landlord has the right to audit a tenant’s books and records, the landlord should also include language in the lease that the landlord will use “commercially reasonable” efforts to cause its agents and employees to hold such records in confidence.

If an audit shows that a retail tenant misreported and understated earnings, the landlord will want some recourse for the cost of the audit and in some leases, may even have the right to terminate the lease if the understatement is big enough.

Generally, the restructuring of a lease occurs as a result of the tenant reaching out to the landlord for reduced rent or other common concessions.

When asking its landlord for a short-term or long-term lifeline (e.g., a free rent concession), the tenant needs to be prepared to offer not only a convincing “tale of woe” and a sensible solution to get them through the challenging times, but also with clear and written authoritative documentation in support of their request to the landlord.

It is not important for a tenant to provide its landlord documents in support of its position when asking its landlord for potential rent relief.

Examples of documents that a landlord should review when considering granting a tenant rental relief includes: (i) tax returns for the past few years; (ii) financial statements; (iii) year to date and comparative profit and loss statements; and (iv) future projections of income and expenses.

Given the minimal upfront costs to a landlord when finding a tenant, landlords shouldn’t consider granting their current tenant any rental relief.

A tenant should inform its landlord of its past timely payments when approaching the landlord for rental relief to further enforce that this relief will be an anomaly and not a regularity.

When seeking rental relief from its landlord, a tenant should be unrealistic and exaggerate their financial woes to the landlord in order to ensure that they receive rent relief.

Tenants who feel they can no longer afford the large space they are currently leasing should consider asking for reduced space in place of rent relief.

Given that you have to give something to get something, a possible tenant tradeoff that a landlord might require in exchange for rental relief is for the tenant to provide a personal guaranty for the rent reduction if the tenant doesn’t live up to the terms of the restructuring agreement.

It is always better for the tenant to simply forward the tenant’s proposal for rent relief to the landlord without providing the landlord with any type of “heads up” about what is being sent over and requested.

Until the FASB reporting changes for private companies become effective subsequent to December 15, 2019, commercial leases will continue to be reported as a balance sheet item.

Once the FASB reporting changes become effective for public companies post December 15, 2018 and private companies post December 15, 2019, commercial space leases will be considered operating leases for accounting purposes.

As a consequence of the FASB reporting changes, which require commercial leases to be considered capital leases, once effective: (i) many companies will “front load expenses,” and (ii) leases of 12 months or less will not need to be reported on a company’s balance sheet (unless the tenant’s lease contains a renewal option and it is “reasonably certain” that it will exercise same beyond the initial 12 month period).

Given that the current FASB reporting changes for public companies require a commercial lease to be considered a capital lease (and effectively be treated as if it is both an asset and a liability), unlike an operating lease, tenants will be required to report the lease on their balance sheet.

For private companies, subsequent to December 15, 2019, notwithstanding that a tenant does not own the space it leases, nonetheless FASB reporting requirements will require a tenant’s commercial lease to be capital in nature.

Once FASB reporting changes are effective for both public and private companies, in addition to commercial leases then being considered capital in nature, a tenant’s obligation to pay rent over the remaining term of its commercial lease will not be considered a liability.

The following are potential impacts of the FASB lease reporting change, tenants may be incentivized to (a) purchase a building for their business operations, (b) enter into shorter term leases, or (c) in certain markets, push to have a purchase option included in their lease.

One potential consequence of the FASB lease reporting changes will be that, in some markets, triple net leases (“NNN”) will gain popularity, given that future payments for operating expenses, real estate taxes and insurance will not have to be reported as liabilities on a tenant’s balance sheet.

FASB reporting changes that require commercial space leases to be considered capital leases for accounting purposes are effective (i) for public companies on December 15, 2018, and (ii) for private companies on December 15, 2019.