For a landlord, rental income looks simple: tenants pay rent and the bank statement proves it. The accounting is less direct. Fixed rent that steps up over the term is spread evenly, rent-free periods are recognized over the whole lease, and a tenant that stops paying forces the lessor to reverse income already booked. Each of those moves a recorded number away from cash.
This guide covers the lessor rules under ASC 842, how to test the rent schedule and what the client should provide. For the lessee side and elections, see ASC 842 lease accounting and private company elections and lease modifications.
Lessor classification
The lessor classifies each lease as sales-type, direct financing or operating using the criteria in ASC 842-10-25. Purchase options, residual value guarantees, or a term covering most of the property's economic life can push a lease into the sales-type or direct financing categories, which can accelerate profit recognition at commencement. Classification is reassessed when a lease is modified, so the audit file needs a classification conclusion for significant leases and for each modification.
Straight-line recognition
Operating lease income with fixed payments is recognized on a straight-line basis over the lease term when collectibility is probable. A public REIT discloses the same policy in its lease note. Where rent escalates or the lease starts with free rent, income recognized exceeds cash received early in the term, and the difference accumulates as a straight-line rent receivable on the balance sheet. That receivable reverses over the rest of the term as cash exceeds income.
Variable payments, such as tenant reimbursements of property taxes, insurance and common area costs, are variable lease income when the lessor has elected to combine lease and non-lease components. Without that election, common area maintenance is a non-lease component accounted for under ASC 606. Recoveries from tenants are amounts the tenant is contractually obligated to reimburse. Percentage rent is recognized when the sales threshold is reached.
Collectibility
Collectibility drives the income pattern. When collection of lease payments is probable, income is straight-line. When it is not probable, a lessor limits lease income to the lesser of straight-line income and cash collected, and a later change in the assessment is an adjustment to lease income in the period it occurs, including reversal of the straight-line rent receivable already recorded for that tenant. One public REIT discloses the policy as cash-basis recognition with previously recognized straight-line rent receivables reversed, along with a general reserve recorded as a reduction of lease income. Collectibility is a lease-by-lease assessment that continues through the term. See the allowance for credit losses entry for how this differs from receivables under CECL.
Risk areas
- Straight-line schedules built in spreadsheets with formula errors
- Free rent, tenant improvement allowances and other incentives treated inconsistently
- Lease modifications and rent concessions without a documented conclusion
- Tenants in default with no collectibility assessment
- Reimbursement income recognized on estimates that do not true up
- Rent roll and general ledger out of agreement
- Related-party tenants at below-market rents
Audit procedures
- Agree the rent roll to the general ledger and test it as information produced by the entity; see audit evidence.
- Select leases for testing by tenant size, new and modified leases, and tenants on watch lists.
- Read each lease for term, commencement date, escalations, free rent, renewal options and allowances.
- Recompute the straight-line schedule and agree the resulting receivable to the ledger.
- Test cash receipts for a sample of tenants to deposits and lockbox reports.
- Test collectibility using aging, payment history, tenant financial information and correspondence.
- Test reimbursements by recomputing pro rata shares against the expense pool and the annual reconciliation.
- Test cutoff for rent billed in advance and for security deposits.
- Review disclosures for lease income components and the maturity analysis of undiscounted lease payments to be received.
Worked example
This example is illustrative. A five-year lease starts January 1 with the first six months rent-free. Rent is $10,000 per month for months 7 through 36 and $11,000 per month for months 37 through 60.
- Months 7 to 36: 30 x $10,000 = $300,000
- Months 37 to 60: 24 x $11,000 = $264,000
- Total rent: $564,000
- Straight-line income per month: $564,000 divided by 60 = $9,400
In year one, the lessor recognizes 12 x $9,400 = $112,800 of income but receives only 6 x $10,000 = $60,000 of cash. The straight-line receivable at the end of year one is $52,800. A client that records income as billed would show $60,000 and understate revenue by $52,800 in year one.
Suppose the tenant stops paying at the end of year two and collectibility is no longer probable. Income recognized through year two is $225,600 against cash of $180,000 (12 months at $10,000 for months 13 to 24 plus the $60,000 from year one), leaving a receivable of $45,600. Under the not-probable rule, that receivable is reversed against lease income and future income is limited to cash received. The auditor tests the date the client concluded collectibility was in doubt, because earlier knowledge points to a cutoff error.
PBC items
- Year-end rent roll with lease abstracts
- Executed leases, amendments and side letters
- Straight-line rent schedule and receivable rollforward
- Accounts receivable aging by tenant
- Reimbursement reconciliations and common area expense pools
- Tenant improvement allowance and incentive schedule
- Collectibility assessment and watch list
- Bank statements, lockbox reports and deposit detail
- Lessor classification memos for new and modified leases
Red flags
- Straight-line receivable growing while occupancy is flat
- Receivable balances for tenants who have vacated
- Straight-line adjustments posted manually at year end
- Rent concessions granted but income unchanged
- Tenant reimbursements with no true-up
- Concentration in one tenant with a late-payment history
- Management intent to refinance or sell tied to reported income
Sources
- Public REIT Form 10-Q for the quarter ended March 31, 2020, Note 7, Leases (sec.gov/Archives/edgar/data/910606/000156459020023379/R17.htm)
- JMCO, "GAAP Accounting Requirements for Real Estate Companies" (jmco.com/articles/real-estate/gaap-accounting-requirements-for-real-estate-companies)
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