Last week I was facilitating The Essential GAAP Update for Banks and Other Financial Institutions for KPMG Executive Education. We were going through the new lease accounting standard (ASC 842) and I was reviewing a class discussion question that had me second guessing the answer I was providing to the participants. The question dealt with how to account for common area maintenance charges and property taxes under ASC 842 and IFRS 16.
Turns out the answer I was providing was correct, but I just didn’t feel confident in my delivery. We had a similar class discussion in our prior year update courses, but it covered the accounting for these charges when they were included in the lease payment (i.e. gross lease) and, essentially, paid by the lessor. This year’s question dealt with these payments when they were paid by the lessee and excluded from the lease (i.e. net lease).
I firmly believe that to truly teach something you need to understand it completely, so much so that you can explain it to a two-year old (a philosophy I picked up from Denzel Washington in Philadelphia). Since I was getting a few glazed looks from the participants, I knew I had better up my game and completely understand the accounting for common area maintenance charges (CAM) and property taxes under the new lease accounting standard!
Let’s deal with CAM first.
ASC 842-10-15-28 requires entities to identify the separate lease components within a contract. An entity shall consider the right to use an underlying asset to be a separate lease component if both the following criteria are met:
- The lessee can benefit from the right to use either on its own or together with other resources readily available to the lessee; and
- The right to use is neither highly dependent nor highly interrelated with other right(s) to use underlying assets in the contract.
Clearly, charges for CAM do not meet these criteria so they are not a lease component. However, ASC 842-10-15-30 states that components of a contract include only those items or activities that transfer a good or service to the lessee. It could be argued that if a lessor did not pick up those charges, the lessee would have to pay for the services separately. As such, CAM would be considered a non-lease component.
ASC 842-10-15-30 requires the consideration in the lease contract be allocated to each separate lease component and non-lease component of the contract. According to ASC 842-10-15-33, this is done as follows:
- The lessee shall determine the relative standalone price of the separate lease components and the non-lease components based on their observable standalone prices. If observable standalone prices are not readily available, the lessee shall estimate the standalone prices, maximizing the use of observable information.
- The lessee shall allocate the consideration in the contract on a relative standalone price basis to the separate lease components and the non-lease components of the contract.
An entity shall account for each separate lease component separately from the non-lease components of the contract. Obviously, the lease components are accounted for in accordance with ASC 842. Non-lease components are not within the scope of ASC 842 and, therefore, are accounted for in accordance with other Topics.
However, there is a practical expedient available! ASC 842-10-15-37 states a lessee may, as an accounting policy election by class of underlying asset, choose not to separate non-lease components from lease components and instead account for all components as a single lease components.
Now let’s talk property taxes. ASC 842-10-15-30 clarifies that components, either lease or non-lease, include only those items or activities that transfer a good or service to the lessee. It states that the following are not components of a contract and do not receive an allocation of the consideration in the contract:
- Administrative tasks to set up a contract or initiate the lease that do not transfer a good or service to the lessee.
- Reimbursement or payment of the lessor’s costs.
Examples of such costs include property taxes and insurance.
Let’s look at an example.
GAAP Dynamics leases an office space in Midlothian, VA that represents 25% of the total space of the entire building. We signed a 5-year lease and pay approximately $2,500 per month, with rent payments escalating 3% each year based on inflation as follows:
- Year 1: $2,500 x 12 months = $30,000
- Year 2: $2,575 x 12 months = $30,900
- Year 3: $2,652 x 12 months = $31,824
- Year 4: $2,732 x 12 months = $32,784
- Year 5: $2,814 x 12 months = $33,768
Lease payments over the 5-year period total $159,276.
This is a gross lease meaning that maintenance, property taxes, and insurance are included in the lease payments. For purposes of this example, let’s assume that relative standalone selling price of our portion of the maintenance totals $1,200 per year (or $6,000 over the 5-year period). Furthermore, let’s assume annual property taxes total $10,000 and property insurance costs $2,000 per year for the entire building. These payments are fixed and our portion is $3,000 per year ($12,000 x 25%).
Separate the Lease and Non-Lease Components
As previously stated, maintenance is a component of the contract, albeit a non-lease component. ASC 842 requires us to separate the lease and non-lease components based on their relative standalone prices. We provided the standalone price of the maintenance ($6,000), the non-lease component, but what about the relative standalone price of the lease component? We would have to find an observable standalone price of a similar office building, excluding maintenance. If an observable standalone price is not available, we would have to estimate one maximizing the use of observable information.
Use of the Residual Approach
Can’t we just separate out maintenance ($6,000) as the non-lease component and call the rest ($153,276) the lease component? Perhaps. 842-10-15-33 states a residual estimation approach may be appropriate if the standalone price for a component is highly variable or uncertain.
Practical Expedient is Available
Do we have to do this? No! A practical expedient is available that permits us to account for the entire $159,276 as a single lease component.
Property Taxes and Insurance
What about the taxes and insurance? They are not considered components of a contract and, therefore, do not receive any allocation of the consideration in the contract. As a result, since they are fixed and this is a gross lease, they are wrapped up in the lease payments.
What about the accounting for property taxes and insurance in net leases?
If a lease is structured as a net lease, the accounting for property taxes and insurance is likely to be different than as set out above. In a net lease, the lessee, not the lessor, is responsible for payment of these items, which are variable.
We’ve already determined that payments for property taxes and insurance are not considered components of the contract and, therefore, do not receive any allocation of the consideration. That’s great, because these items are already separated from the lease and we should not add them back in.
Therefore, in a net lease, variable payments by the lessee for property taxes and insurance are excluded from lease payments, whereas in a gross lease, fixed payments by the lessor for such items are included in the lease payments. Weird, I know!
See Example 12 within ASC 842 for further information (ASC 842-10-55-141 through 55-145) for further information.
What about IFRS 16?
You’ll be happy to learn that there are no differences in the accounting for these charges under IFRS as compared to U.S. GAAP! Here’s a summary of where the guidance set out in this post can be found in IFRS 16:
- IFRS 16.12 requires separation of lease and non-lease components.
- IFRS 16.13-.14 prescribes how lessees allocate consideration to lease and non-lease components.
- IFRS 16.15 permits the same practical expedient to consider all components lease components.
- IFRS 16.B33 talks about activities and costs that do not transfer goods or services to the lessee and, therefore, are not considered components of the lease.
So, there you have it! I hope this post has helped you understand the accounting for CAM charges, property taxes, and insurance under both ASC 842 and IFRS 16. Be sure to check out this post for a list of resources to help you navigate the new standards. Now get outside and enjoy that freshly landscaped office complex courtesy of the CAM charges and enjoy some sunshine!
Disclaimer
This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.
Comments (23)
Maria:
May 10, 2018 at 08:35 PM
this is by far the best article I have found on how to deal with CAM charges. I'd consider our contract a gross lease, but the CAM charges are more separately identifiable than in the example. Our rent per sqft/year is $22. In addition to that we pay $11 for operating expenses (maintenance, cleaning common areas etc) and we pay $3 for taxes. All in all total monthly cost is $36 per sqft/year, or 3$ per sqft/month.
At the end of the year we receive a reconciliation that trues up the $14 CAM and taxes. Some years we pay extra, some years we get a refund. So it seems very specific and identifiable. Do we include the CAM/taxes when setting up the deferred rent schedule (i.e. do we consider those to be part of the straight line expenses too)? Thank you! Maria (Bellevue, Washington)
Mike Walworth, CPA:
May 13, 2018 at 07:24 AM
Maria,
First, thank you for the compliment! I think the answer to your question is addressed by Example 12 / Case A (ASC 842-10-55-141 and 55-142) which I've included below:
Lessor and Lessee enter into a five-year lease of a building. The contract designates that Lessee is required to pay for the costs relating to the asset, including the real estate taxes and the insurance on the building. The real estate taxes would be owed by Lessor regardless of whether it leased the building and who the lessee is. Lessor is the named insured on the building insurance policy (that is, the insurance protects Lessor’s investment in the building, and Lessor will receive the proceeds from any claim). The annual lease payments are fixed at $10,000 per year, while the annual real estate taxes and insurance premium will vary and be billed to Lessee each year.
The real estate taxes and the building insurance are not components of the contract. The contract includes a single lease component— the right to use the building. Lessee’s payments of those amounts solely represent a reimbursement of Lessor’s costs and do not represent payments for goods or services in addition to the right to use the building. However, because the real estate taxes and insurance premiums during the lease term are variable, those payments are variable lease payments that do not depend on an index or a rate and are excluded from the measurement of the lease liability and recognized in profit or loss in accordance with paragraph 842-20-25-5 or 842-20-25-6.
Hope this helps!
Mike
Mike Walworth, CPA:
May 13, 2018 at 07:29 AM
Maria,
This is part II, which I think gets to what you were asking. The guidance above clearly says that your CAM charges are not components of the contract and, therefore, are not considered when setting up the initial lease liability. However, ASC 842-20-25-6 (I'm assuming you have an operating lease) states they are included in the overall expense for the year:
After the commencement date, a lessee shall recognize all of the following in profit or loss, unless the costs are included in the carrying amount of another asset in accordance with other Topics:
a. A single lease cost, calculated so that the remaining cost of the lease (as described in paragraph 842-20-25-8) is allocated over the remaining lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset (see paragraph 842-20-55-3), unless the right-of-use asset has been impaired in accordance with paragraph 842-20-35-9, in which case the single lease cost is calculated in accordance with paragraph 842-20-25-7
b. Variable lease payments not included in the lease liability in the period in which the obligation for those payments is incurred (see paragraphs 842-20-55-1 through 55-2)
c. Any impairment of the right-of-use asset determined in accordance with paragraph 842-20-35-9.
Your CAM charges would be included in (b) above.
Mike
Eric Krone:
Sep 27, 2018 at 05:44 PM
Amazingly simple example of CAM charges. Thanks for the insight.
Mike Walworth, CPA:
Sep 27, 2018 at 08:46 PM
My pleasure. Thanks for reading!
Ernetta Roper:
Dec 06, 2018 at 07:28 AM
For a car lease or even a copier lease, would sales tax be considered a non-lease component? For example, if the monthly payment on the lease is $1,080, with $1,000 lease payment plus $80 for sales tax, would the $80 sales tax be considered part of lease liability or would it be considered a non-lease component?
THV:
Jan 04, 2019 at 06:28 PM
Hi Mike,
Very helpful article. I know property taxes are specified as executory costs but what about VAT, GST or consumption taxes for the foreign entities with rates known as inception? We have leases that have those components. In the past, under ASC 840, we were excluding and reporting net. But now, with the implementation of ASC842, I'm starting to think it should be included.
Mike Walworth, CPA:
Jan 30, 2019 at 12:47 PM
Thanks for the question, THV. And sorry for the late reply. We were dealing with some spam issues and I wasn't being notified of legitimate questions on the blogs.
To answer your question, I believe that taxes like VAT, GST, etc. would be treated the same way as the property taxes noted in the article. That is, they are neither a lease nor a non-lease component (and the accounting would differ depending on whether the lease was gross or net, as described above). Check out Sections 1.4.2.1 and 2.4.9 in EY's Guide for more information. It is available at this link:
file:///Users/MichaelWalworth/Downloads/financialreportingdevelopments_00195-171us_leaseaccounting_17january2019.pdf
Hope it helps!
Mike Walworth, CPA:
Jan 30, 2019 at 12:49 PM
THV,
Sorry, I realized the link above went to my downloads (which doesn't help you much)! You can find it easily with a Google search of "EY leases 842".
Mike
Cory:
Feb 01, 2019 at 02:28 PM
Hi Mike,
I have a number of leases where I am the tenant. I was hoping for some guidance.
(a) If I have a lease payment that started before ASC 842 takes hold (10 years ago), and the changes in annual rent payments are based upon the change between CPI index points, is my initial lease base rent for calcuating the liability the initial charge or the base charge at ASC 842 implementation? Say 10 years ago my initial rent was $2,000 per month and now I am paying $2,800. Do I record the initial calcuations on the $2,800 or the $2,000 and the $800 goes to expense?
(b) If I have a triple net lease and CAM charges that vary each month, I assume the CAM charges are variable and recognized through expense, correct?
(c) If I have triple net lease and CAM charges that are constant each month and then trued up at year end, are those CAM charges to be considered part of the liability or just the expense? My interpretation would be they are part of the expense and not the base rent.
Thank you so much for any help!
Cory
Betty:
Mar 06, 2019 at 06:57 PM
If tenant is offered free CAM, does it mean that the landlord has to cover that free CAM, any authorities on that?
Mike Walworth, CPA:
Mar 15, 2019 at 05:16 PM
Ernetta,
I realized I did not reply to your question regarding sales tax. See my response to THV regarding GST, VAT, etc. That is, I believe that these type of taxes are neither a lease nor a nonlease component, but rather a non-component. The accounting for non-components (e.g. taxes and insurance) depends on whether they are included (i.e. gross lease) or excluded (i.e. net lease). If they are already included, you don't break them out. If they are excluded, you don't put them back in. Hope it helps!
Mike Walworth, CPA:
Mar 15, 2019 at 05:32 PM
Cory, thanks for your question (and thanks for reading). My apologies for not getting back to you sooner.
On the first question (a), obviously when you would need to make this determination (i.e. the application date) depends on the transition method you choose. However, conceptually, the lessee would measure the ROU asset and lease liability at the application date. Therefore, in your example, you would use the $2,800. Any subsequent increases in CPI would go to expense.
On the second question (b), obviously CAM charges are considered non-lease components and should be separated out from lease components. That is, unless you've chosen to not separate them from lease payments as permitted by ASC 842. If you've chosen to separate them, then all of the CAM charges are recognized in the P&L apart from rent expense, including any variability. If you've chosen to include them, then the initial amount is included in lease payments (and recognized in P&L as part of lease expenses) and any variability would be expensed outside of lease payments (similar to variable payments based on an index or rate when the rate increases).
Regarding question (c), I think the same guidance as discussed for (b) would apply, which means yes, they would be included in expense when "trued up" (outside of lease expense).
Hope it helps!
Mike
Paige:
May 05, 2019 at 12:28 PM
Hi Mike,
I have question regarding software licenses. Are these considered lease components or should they be treated in same manner as non-lease components? Can't seem to find any clear guidance in this area. With regard to sale tax/ rent tax / use tax, I thought use tax could be included in the measurement of the lease payments and liabilities if the tax was included in the lease payment (i.e. lessor is collecting use tax and pay use tax on behalf of the lessee). If the lessee is paying the use tax directly to the local jurisdictions, then in that case use tax can be separated from the lease payments and accounted for separately. Can you please help clarify which is the correct interpretation? Thanks.
Mike Walworth, CPA:
May 16, 2019 at 02:14 PM
Paige,
I believe the licenses of software (an intangible asset) would be scoped out of ASC 842. Therefore, yes, they would be considered non-lease components. Regarding your use tax question, I refer you back to this bit in the blog post:
Property Taxes and Insurance
"What about the taxes and insurance? They are not considered components of a contract and, therefore, do not receive any allocation of the consideration in the contract. As a result, since they are fixed and this is a gross lease, they are wrapped up in the lease payments."
So, yes, if it is a gross lease, they are essentially "wrapped up" in the lease payments. Note, however, this accounting would differ if it is a net lease (as noted in the post above).
Hope it helps!
Mike
Jennifer:
Jun 19, 2019 at 02:23 PM
Hi,
My question is- is it possible to straight line real-estate tax payments to the LL(I am a lessee, and simply reimbursing for the tax as part of the lease)? However, due to a slowdown in the market I would like less of a P&L recognition this year? (Note- i am a lessee, the lessor is the property owner, with the statutory obligation to pay the tax to the state)
Also- is it possible to defer real-estate tax payments to the LL? IE: recognize $0 year 1 & 2, and reimburse the LL double in year 3 & 4, even though those taxes pertained to a prior period (with no accrual in place)?
Thank you!!
Jenn
Leah Aikey:
Jul 18, 2019 at 02:55 PM
In regards to utility payments related to a lease. I realize if it is a gross lease then these are included in lease payments. If it is a net lease and we elected to combine lease and non-lease components and they are included in CAM in the lease then these are variable lease cost if they are not fixed, correct? It seems from what I am reading up on that if these are subject to an annual true-up then the stated monthly payment should be included in the ROU asset and liability as lease payments, is that correct? Is this considered an in substance fixed payment? This is treating these the same as CPI leases, where just the annual increases or in this case the annual true-up is the variable expense. Am I understanding this correctly? If the utility bills for electric, gas, water, sewer, etc are billed directly to the lessee from the third party are these treated as variable lease cost and included in the disclosure the same as the invoices received from the lessor monthly for reimbursement? It would make sense that these are treated as variable lease cost no matter if a reimbursement to the lessor or if paid directly to a third party if they are invoiced monthly and variable. There is not much guidance directly on utility costs related to leases so I wanted to make sure I understood the treatment correctly. Thank you!
Vincent:
Oct 28, 2019 at 12:55 PM
My question involves a copier lease. Our company is under a 5 year lease for multiple copy machines at one contracted lease amount for all copiers. As part of the contract, we have a monthly usage for B&W as well as color copies. Once we go over the usage, there is a charge per image. The charges vary monthly based upon our usage. Would this be considered a lease component and included as part of the PV Calculation to determine lease liability for the fixed lease payment as well as the variable imaging charges? I would assume based upon usage expectations?
Brendon Andrade:
Feb 27, 2020 at 09:39 PM
Talking about lease cost disclosure. Other than lease expense that is part of leases that are measure in lease liabilities, what other lease cost should be included in financial disclosures? For example, should variable CAM payments that weren’t measured in the right of use asset be included in lease cost disclosure? What are examples of other variable lease cost that need to be included in lease disclosures (similar to short term leases for entities that elected practical expedient). Thank you, very helpful article!
JACQUELINE U BAUTISTA:
Oct 06, 2022 at 12:16 PM
Thank you so much for this article! It's been very very helpful, especially for small business owners. I am currently entering a new lease for under a NNN lease. I have calculated the total contract amount (base rent only) and separately calculated the NNN (prefer to recognize as an expense if permitted). How would I determine the initial amounts for ROU asset and lease liability? Do I present value the total base rent?
Mike Walworth, CPA:
Oct 10, 2022 at 09:40 AM
Jacqueline, thanks for your question. In triple net lease, the lessee is responsible for the property taxes and insurance, as well as the common area maintenance. As discussed in the post, these items are NOT part of the lease payments. Therefore, you are correct, you would present value the remaining unpaid lease payments to get the lease liability and, assuming there are not any initial direct costs, lessor incentives received, or prepaid rent, that would also be your ROU assets. However, you said "base rent." Just make sure you are calculating lease payments correctly. In other words, don't forget about the variable lease payments based on an index or rate that also need to be included in the lease payments when calculating your lease liability. Hope it helps!
Kate:
Feb 21, 2023 at 11:47 AM
Thank you for explaining this! Can you please confirm my understanding?
Example: Lessee of a net lease rental contract that stipulates the fixed base monthly rent amount and simply says that Lessee is responsible for all other costs (CAM, utilities, insurance and taxes) which are variable (not by index or rate) and billed by third party supplier. Practical expedient to not separate lease and non-lease components is elected. A LL and ROA is recorded and calculated as the PV of future payments based on the fixed base monthly rent. All other variable costs are expensed as incurred. The fixed monthly base rent would be disclosed under operating costs. Do the variable costs (CAM, utilities, insurance and taxes) need to be disclosed under variable lease cost section?
Mike Walworth, CPA:
Feb 22, 2023 at 04:30 PM
Kate, thanks for your question. Since the lease is a NET lease and any additional payments are paid to a third-party supplier, I don't think these additional payments meet the definition of variable lease payments set out in ASC 842. Here's the definition:
Variable Lease Payments - Payments made by a lessee to a lessor for the right to use an underlying asset that vary because of changes in facts or circumstances occurring after the commencement date, other than the passage of time.
So my answer would be "No" the variable costs that you described in your question are not variable lease payments as defined and, therefore, should not be disclosed under the variable lease cost section.
My two cents. Mike
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