The upcoming changes in the Financial Accounting Standards Board (FASB) revenue recognition standards require new accounting methods by lessors and property managers, who manage properties that are under long-term leases (longer than twelve months). In a previous post, Revenue Recognition for Property Management Professionals we gave a broad overview. In this post, we go into further details about the changes in accounting for long-term leases.
Changes in Lease Accounting Rules that Affect Property Managers
Under the new lease accounting rules, long-term leases will be reported by the lessee on the balance sheet as two components, which are: 1) an asset that is the value of the right-of-use; and, 2) a lease liability, which is the present value of all the required lease payments that will be paid under the lease agreement less any allocations made for non lease components.
The allocation calculations for non-lease components are based on the FASB general rules of Accounting Standards Codification (ASC) 842. ASC 842 allows a lessor or property manager to choose not to separate non-lease components from lease components as a specific election for an asset class.
If the election is not made for a specific asset class, the new rules require lessors and property managers to differentiate lease components from non lease components. An example of a non lease component is CAM (Common Area Maintenance) that could be a separate charge or included as part of the gross lease payment. Recoverable expenses, such as payments made by the lessor for insurance, property taxes, and so forth that are reimbursed by the lessee are accounted for differently under the new rules. Accounting for land is now separate under the new rules. The types of leases also affect the accounting procedures.
Accounting for Common Area Maintenance and Recoverable Expenses
The new lease accounting rules require separate accounting for CAM (Common Area Maintenance) and recoverable expenses. CAM payments are those made by a lessee for the common areas used by all the tenants at a particular location. Examples of CAM expenses include maintenance of the lobby, elevators, parking lots, and seasonal decorations put up in the common areas.
Under the new rules, the CAM expenses are separated from the lease payments. If the CAM payments are not a separate line item amount and instead, they are included in the gross lease payments then an allocation needs to be made to determine the non lease components of the gross lease payments. Lessors and property managers need to determine what the non lease components would cost at fair market prices if they were billed for and paid for separately from the lease payments.
CAM payments are expenses and treated as such by appearing on the income statement. They are deducted from the lease payments and therefore reduce the long-term lease liability amount that appears on the balance sheet of the lessee under the new rules. From a property manager’s perspective, any tenant reimbursements for recoverable expenses are deducted from the actual expenses made by the property manager or lessors for CAM.
Accounting for Land and Buildings
Under ASC 842, if the lease includes building(s) and the right to use land, the land must be accounted for separately, unless there is not a significant effect of using combined accounting for the land and the building(s). If the lease includes more than one building, each building is accounted for separately if its use is not dependent on another building under the lease. Any buildings that must be used together to function properly are accounted for as one leased unit.
Accounting for Different Kind of Leases
The valuation of the lease contract and the accounting for the lease payments depends on the lease classification. There are different accounting methods under the new rules for a sales-type lease and an operating lease. A sales-type lease differs from an operating lease, in that the underlying asset is transferred to the lessee at the end of the lease or an option for the lessee to buy the asset happens at the lease termination. There are other criteria for a sales-type lease and some of those types of leases have the classification of a direct finance lease, where the present value of all the lease payments and the residual value equals or exceeds the underlying asset value. It is important to evaluate all lease contracts to determine their proper classifications under the new rules.
In this brief overview, it is not possible to discuss all the pertinent details of the various impacts for lessors and property managers from the new rules. The changes in the accounting rules are complex and significant. It is best to contact the experts at Palazzo Inc. for a complete assessment of your current situation.
Here is a resource that we recommend to gain further knowledge on this subject:
How the FASB’s new leases standard will affect real estate entities
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