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. Now get outside and enjoy that freshly landscaped office complex courtesy of the CAM charges and enjoy some sunshine!
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