Lessee Considerations Upon Adopting ASC 842
With the adoption of ASC 842, lessees are having to analyze operating leases more thoroughly than they were ever required to do under legacy U.S. GAAP (ASC 840). While there are a number of areas that will need to be considered in detail, this article will focus on the following:
- Understanding non-lease components included in a lease;
- The practical expedient not to separate non-lease components from lease components; and
- Understanding the difference between a gross and net lease in the measurement of the right-of-use (“ROU”) asset and related lease liability.
Under ASC 842, lessees must apply certain criteria to determine whether a contract that contains a lease includes a lease component and one or more non-lease components that should be accounted for separately. During the implementation of ASC 842 and for leases entered into subsequent to the adoption of ASC 842, companies must determine whether a lease includes a lease component and one or more non-lease components. If there are non-lease components, the FASB has allowed lessees to choose to either:
- separate lease components from non-lease components by allocating the contract consideration to the components based on their relative standalone prices; or
- elect a practical expedient, by class of asset, whereby non-lease components are not separated from the lease component. This would result in all of the lease and non-lease components being combined, and accounted for, as a single lease component.
It is important for companies to understand the accounting implications and the operational challenges that arise as a result of selecting the practical expedient.
The practical expedient is intended to reduce the administrative burden of separating multiple components and accounting for each of them separately. While it may be operationally impossible for a company to separate and track every non-lease component in every lease, the issue is that in electing the practical expedient both the lease and non-lease components could be included in the measurement of the ROU asset and related lease liability. If the non-lease components are significant, the gross up on the balance sheet could potentially impact covenant ratios and other financial metrics.
Definition of a non-lease component.
ASC 842-10-15-30 requires that the consideration in the contract shall be allocated to each separate lease component and non-lease component of the contract. Components of a contract include only those items or activities that transfer a good or service to the lessee. Consequently, the following are not components of a contract and do not receive an allocation of the consideration in the contract:
a. Administrative tasks to set up a contract or initiate the lease that do not transfer a good or service to the lessee.
b. Reimbursement or payment of the lessor’s costs. For example, a lessor may incur various costs in its role as a lessor or as owner of the underlying asset. A requirement for the lessee to pay those costs, whether directly to a third party or as a reimbursement to the lessor, does not transfer a good or service to the lessee separate from the right to use the underlying asset.
Real estate taxes and insurance.
Based on ASC 842-10-15-30(b), real estate taxes and insurance do not transfer a good or service to the lessee. As a result, they are not components of a contract because of the following:
- The property taxes being reimbursed to the lessor are the lessor’s costs because they would be owed by the lessor regardless of whether it leased the building and who the lessee is; and
- The building insurance is a lessor cost because the lessor is the named insured on the building insurance policy, and therefore the policy principally benefits the lessor by protecting the lessor’s investment in the building.
Common area maintenance charges (“CAM”).
Many lease agreements provide services performed by the landlord to maintain the property and common areas which include landscaping, janitorial services, snow removal and repairs. These services are typically known as CAM. As a result, the landlord is providing a service to the lessee other than the right to use the underlying asset (rent). Therefore, CAM is a non-lease component and a portion of the consideration in the lease agreement would be allocated to CAM.
SEPARATING NON-LEASE COMPONENTS FROM A LEASE COMPONENT
If a company does not elect the practical expedient, it will have to perform the following for every lease:
- Identify lease and non-lease components; and
- Determine the relative standalone selling price (fair value) of each lease and non-lease components and allocate the consideration to each.
Imagine how much effort and resources would be needed by the company – and the subsequent effort to get the company’s outside accountants comfortable!
Understanding the practical expedient at the date of adoption.
The transition guidance in ASC 842-10-65-1(l) requires a lessee to use its remaining minimum rental payments (which are defined consistently with Topic 840) as an input to measure its lease liability for leases previously classified as operating leases under ASC 840. However, ASC 840 does not define minimum rental payments. Further ASC 840 is not clear on whether executory costs (real estate taxes, insurance and CAM) should be included as part of the minimum rental payments.
Under ASC 840, some companies included the executory costs while others excluded the amounts from the minimum lease payments thus creating diversity in practice. The SEC staff addressed this point and stated that the lessee should follow its existing policy under ASC 840 to include or exclude executory costs when determining its minimum rental payments to a calculate the ROU asset and lease liability when transitioning from ASC 840 to ASC 842.
GROSS AND NET LEASES
Companies will also need to consider how the difference between a gross and a net lease impacts the measurement of the ROU asset and lease liability.
In a gross lease, the tenant typically pays a fixed base rent amount that takes into consideration that the landlord covers its estimated expenses for the real estate taxes, insurance and CAM. The tenant pays the same fixed base rent regardless of whether the expenses end up being higher or lower than estimated amount. Since the real estate taxes, insurance and CAM are fixed and are included as part of the fixed base rent in a single lease payment the entire amount would be used in the measurement of the ROU asset and liability, thereby creating a larger ROU asset and lease liability.
However, in a net lease, the tenant pays a fixed based rent and, in addition, its pro rata share of the landlord’s actual real estate taxes, insurance and CAM. Since the real estate taxes and insurance are already separated from the lease, and as discussed above they do not transfer a good or service to the lessor, they are not components of a contract. Accordingly, the real estate taxes and insurance would not be included in the measurement of the ROU asset and lease liability. However, depending on the structure of the lease agreement, the tenant’s payment for CAM could consist of a fixed payment that would be included in the measurement of the ROU asset and lease liability or a variable payment that would not be included in the measurement of the ROU asset and lease liability.
Understanding the difference of whether to include or not include a fixed and variable CAM payment in the measurement of the ROU asset and lease liability in net lease.
Example 1: At the inception of the lease agreement. the landlord establishes a fixed CAM amount that is payable monthly by the tenant that remains constant over the lease term. However, at the end of each year, the landlord provides the tenant a reconciliation of its actual costs incurred during the year. The CAM is trued up at the end of each year based on the landlord’s actual costs incurred during the year and the tenant pays the trued up amount based on its annual pro rata share at the end of the year or monthly in the following year. In this example, the fixed amount that was determined at the inception of the lease agreement would be included in the measurement of the ROU asset and lease liability since the amount is fixed. However, the variable payment for the true up would not be included in the measurement of the ROU asset and lease liability.
Example 2: The tenant's annual pro rata share of CAM is estimated by the landlord at the inception of the lease agreement; this sum is typically known as a base-year amount paid monthly by the tenant. At the end of each year, the landlord provides the tenant a reconciliation of its actual costs incurred during the year which the tenant is responsible for the difference between the base year amount and its pro rata share of the landlord’s actual costs. A new base-year amount is established based on the tenant’s pro rata share of the landlord’s actual costs in the preceding year, regardless of whether the amount ends up being lower than the previous base year’s amount. In this example, the CAM payments would be considered variable and not included the measurement of the ROU asset and liability.
When adopting ASC 842, as well as when entering into leases prospectively, companies should consider whether the reduced administrative burden resulting from electing the practical expedient will impact covenant ratios and other financial metrics as a result of the larger ROU asset and lease liability. Also, by careful structuring a new lease agreement, a company could minimize the impact of the ROU asset and lease liability on its balance sheet.