Back in the 1980s, having “flexible” office space meant having secondary space that could be used as needed. Today, “flexible” office space has taken on a new meaning and the demand for it has grown tremendously in recent years. Driven by advancements in technology, along with new economic and cultural trends, companies large and small are increasingly looking to optimize their real estate portfolios to attract and retain talent and remain nimble in a rapidly changing business environment. Flexible space solutions meet this need by coupling lease-term flexibility with highly appealing workplace environments and amenities.
A flexible-space membership agreement offers occupiers space for terms ranging from month-to-month to as long as five to ten years. However, the flexible terms of a flexible-space membership agreement, combined with the principles-based definition of a lease, have created a bit of an accounting conundrum: are these agreements “leases” as defined by the new accounting standards and, if so, why do we care?
This determination is important because if the agreement is not technically considered a lease, it falls outside the scope of the new lease accounting standards and does not have to be recorded on a company’s balance sheet. Depending upon the size of the space in question, the financial impact of this determination could be a major factor in a company’s decision-making process.
“The unique characteristics of many flexible-space agreements can make it difficult to determine whether they are in fact leases. This is complicated further by the reality that flexible space can take on many different forms and flexible space providers are constantly evolving their business models in real time,” says Jeff Beatty, Senior Managing Director, Financial Consulting Group & Director, Global Task Force on Lease Accounting, CBRE.
WHAT MAKES AN AGREEMENT A "LEASE?"
According to the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), a lease is a contract that “conveys the right to use an identified asset for a period of time in exchange for consideration.”
“For many companies, this typically means set space within a building (or the entire building) for a set period of time and at a specified rate per square foot. Just because the document is called a membership agreement doesn’t mean it’s not a lease,” says Eileen Chan, Executive Director, Financial Accounting Advisory Services, EY.
WHAT TYPES OF FLEXIBLE OPTIONS ARE AVAILABLE
The two most common flexible-space options are coworking agreements and enterprise agreements.
Companies that utilize coworking spaces have the ability to use a specific number of desks or an allotted work area and typically share the space with other short-term users. The terms of the coworking agreements themselves are short, ranging from month-to-month to a specified term of upwards of five years. In some cases, automatic renewals are part of the agreements.
“Both coworking and customizable enterprise solutions are allowing our clients to strategically implement flexible lease structures into their global footprints, while benefiting from high-quality finishes in Class-A locations with little or no capital cost. It’s a value proposition that is hard to ignore, and we are seeing everyone from startups to Fortune 500 corporations consider flexible space for a growing number of office requirements,” says Michael Dash, Vice Chairman, CBRE.
Companies using enterprise agreements for their requirements are provided a dedicated space ranging from partial to entire floors — and in some cases, an entire building. These agreements usually range from three to 10 years. The tenant also has the ability to customize the space, making an enterprise space feel more like their own office than a coworking environment.
IF A COMPANY IS RENTING A FLEXIBLE WORKSPACE, IS THE AGREEMENT A LEASE?
Between enterprise agreements and coworking agreements, it is the latter that wades deeper into the grey area of whether a lease exists. For instance, is the location of the seats that a company is renting clearly defined? Does the flexible space provider have the right to substitute the tenant’s seats or the location itself?
The terms of an enterprise agreement are comparably more defined with tenants having a dedicated space for a specific period of time with the space itself being customizable. As a result, these agreements are more likely to be considered leases.
“If the tenant’s seats or location is defined in the terms and conditions of the arrangement, it could be an indication that the agreement meets the definition of a lease,” says EY’s Ms. Chan. “If it is a lease, it is subject to the new lease standard which could require the lease to be recorded on the balance sheet of the company. If not, the cost associated with the arrangement would simply be expensed as incurred.”
However, even if an agreement is determined to be a lease, there are more nuances to address.
IS IT A "SHORT-TERM" LEASE?
If it is determined an agreement is a lease, this does not automatically mean it must be recorded on the company’s balance sheet. This is because both the FASB and IASB standards allow for a “short-term” lease exception.
“A short-term lease is defined as any lease with a lease term of 12 months or less. If this is the case, at the discretion of the lessee, the lease does not have to be recorded on the company’s balance sheet,” says CBRE’s Mr. Beatty.
WHAT IS THE "LEASE TERM" FOR ACCOUNTING PURPOSES?
It is important to note that for accounting purposes, the lease term must include any renewal option periods “reasonably certain” of being exercised. For example, if a lease has a primary term of one year with a one-year renewal option that is “reasonably certain” of being exercised, the lease term will be two years for accounting purposes. As a result, it will not meet the short-term lease exception and must be recorded on the company’s balance sheet.
Flexible agreements, especially coworking agreements, are used generally for shorter lease terms and may have multiple short-term renewal options (in some cases automatic one-year renewals). As a result, the “reasonably certain” option may come into play in determining whether a flexible agreement identified as a lease must be recorded on the balance sheet.
SO, WHAT DO WE CALL IT?
While the typical coworking agreement seems unlikely to be considered a lease, most enterprise agreements strongly resemble leases. Unfortunately, there is no one-size-fits-all answer.
“We believe that individuals with a role in sourcing, negotiating, administrating or accounting for the enterprise agreements or coworking agreements should have a good understanding of the nuances of the new lease standard together with the company’s own accounting policies in order to avoid any unwarranted accounting surprises,” EY’s Ms. Chan adds.
While the agility that companies seek by utilizing flexible space is of primary importance, a company should be aware of the impact this agreement may have on its balance sheet, prior to entering into the agreement.
While the impact to the balance sheet could be a factor in the decision-making process, it is generally not anticipated to be a driving factor for most companies.
“For companies that are considering a flexible agreement, it is important to understand the accounting treatment and whether the agreement will be recorded on your balance sheet,” says Brandon Forde, Executive Managing Director, Advisory & Transaction Services, CBRE.