3 common mistakes in lease accounting
A collective sigh of relief from the small-business community was practically audible last month when the Financial Accounting Standards Board voted to delay the adoption date of Accounting Standards Codification Topic 842 — the new standard for leases under generally accepted accounting principles — for private companies from fiscal years beginning after Dec. 15, 2019, as originally intended, to fiscal years beginning after Dec. 15, 2020.
The deferral, which gives private companies two more years to adopt new standards compared to their public company counterparts, was the result of overwhelming feedback from businesses reporting they were struggling to implement the new standard in the allotted time.
While private companies can now breathe a little easier, public companies have had to follow the new standard, in most cases, for nearly a year. As a public accountant specializing in lease accounting, my team has advised multiple companies through their adoptions of ASC 842, and what we’ve found is that businesses are consistently having some of the same missteps. These include determining the owner of and proper accounting for tenant improvement allowances, overlooking impairment of right-of-use assets in sublease arrangements, and mistreatment of common area maintenance charges when assessing lease and non-lease components of a contract.
With the deadline to adopt ASC 842 extended, though nonetheless looming, here are just three examples of where the new standard can be complex during the adoption, and how to correctly account for these lease-related arrangements.
1. Ownership of leasehold improvements
Tenant improvement allowances to renovate or retrofit office space are a common incentive offered by commercial realtors to bring in tenants. These allowances, or other lease incentives, are defined under ASC 842 as improvements paid to or on behalf of the lessee by the landlord.
As companies are now required to record assets related to operating lease obligations, there appears to be confusion surrounding the proper treatment of tenant improvement allowances, as previous GAAP required an entry to create a leasehold improvement with an offset to deferred rent liabilities. With an asset already on the books for right-of-use assets, do companies still need to record a leasehold improvement for tenant allowances?
The answer is: It depends on a careful analysis of who the accounting owner of the leasehold improvement is, on a case-by-case basis. This analysis should focus on which party has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. In other words, control is the deciding factor here.
Does it matter if the landlord is paying for those expenses directly? No, it does not. However, careful consideration should be given to the timing of recording these expenses when the landlord is paying for them directly based on the specifics of the agreement and your situation.
2. Subleases: Impairment of right-to-use assets
Subleasing spaces to third parties is another common leasing activity that tends to create accounting complexities. First, it’s important to remember that companies that are not relieved of their primary obligation under the lease must still record the operating lease per ASC 842-20-35, just as they did prior to the commencement of the sublease.
That aspect of the provision certainly appears simple enough, but the real confusion results when a company subleases space to a third party for a lower rate than what it is paying the landlord. ASC 842-20-35 makes clear that as soon as this kind sublease is contracted, the original leasing party immediately incurs an impairment, or should reduce the value, of the right-of-use asset (i.e., the office space). If this event occurred prior to the adoption of ASC 842, you may have an immediate hit to retained earnings upon adoption of the lease standard. This is a new item that wasn’t present under previous GAAP, so it’s important to make sure your team is being proactive and on the lookout for this kind of scenario.
3. Common area maintenance charges
In our experience, most companies are electing to take the practical expedient related to building leases to combine lease and non-lease components in their accounting analysis. While the practical expedient can simplify things somewhat compared to the initial ASC 842 requirement that lessees separate lease and non-lease components, confusion arises for how to treat common area maintenance charges (“CAMs”).
Common area maintenance charges — those expenses, specified in the lease agreement, to be paid by tenants to cover maintenance and other upkeep — by default fall in the non-lease category, as they represent the transfer of a service other than the right of use of the underlying asset. If you are not electing the practical expedient, CAM costs must not be included in your lease liability calculation, as these are non-lease components. And if the lease payment includes these expenses as a single dollar payment amount, you must estimate and allocate the transaction price between the two components.
However, if you do take the practical expedient, determining whether CAM expenses should be included in your lease payments for purposes of calculating your operating lease liability and right-of-use asset is a bit trickier. Here, the key distinction is whether the lessor and lessee agreed to fixed CAM amounts or to CAM expenses that are to be a proportion of the building’s expenses. If the amounts are fixed monthly amounts, or fixed amounts plus variable increases per an agreed-upon index or rate, CAM expenses would be included in your calculations, as outlined in ASC 842-10-30-5. If, on the other hand, CAM amounts are simply a share of the building’s expenses, they would not be considered an in-substance fixed payment and therefore would not be included in your lease obligation calculations.
Don’t repeat these mistakes
As we and other advisors have learned in the past year, the new lease accounting standard is not straightforward. This additional year granted by the FASB represents an opportunity for privately held businesses to learn from the mistakes of public businesses and early adopters that had far less guidance. So, as businesses continue to prepare for adoption of the new standard, they need to make sure they take the time to understand the new standard and that they don’t repeat these common mistakes.