Operating Costs – A Review and Something New

Capital Expenditures – Amortization and Depreciation & Upcoming IFRS Changes to GAAP

Are capital expenditures properly recoverable as Operating Costs? How relevant are the International Financial Reporting Standards (IFRS) soon to be implemented in 2011 to this topic? Although the definition of “Operating Costs” in most leases includes capital costs, tenants generally take exception to this. Case law has left us with little guidance about the meaning of the phrase “capital costs” and/or “costs/expenditures of a capital nature”. Many leases give reference to “capital costs in accordance with GAAP” in their definitions of “Operating Costs”; however, the CICA refers to the concept of “betterment”, excluding the term “capital costs”. Based on the CICA Handbook’s definition of “capital assets”, we can conclude that expenditures incurred to create, acquire or improve a capital asset would amount to a capital cost. An expenditure incurred to repair a capital asset, however, would not fall under this definition. Further, a cost incurred to generate revenue or operate the business would not constitute a capital cost.

Defining capital costs is not the only challenge for landlords and tenants. There is often debate about how capital costs included in Operating Costs under a net commercial lease will be passed on. Specifically, the debate relates to whether capital costs will be fully charged in the year in which the cost was incurred, whether the expenditure will be amortized and what method of amortization will be used. There is confusion over the differences between amortization and depreciation. The CICA Handbook no longer uses the term “depreciation” and some leases only allow the recovery through Operating Costs of “amortization, but not depreciation”. The intention behind this may be to allow certain costs, incurred to replace and/or improve an asset, to be spread out and recovered over a period longer than a year, but to disallow recovery of the original cost of the initial acquisition on a “sinking fund” basis. Further issues relating to amortization arise where a tenant under a new lease pays amortization relating to an expenditure incurred prior to the lease commencement date or on the other hand, if landlords are entitled to recover an interest cost on the unamortized portion of the capital cost.

It is important for landlords and tenants who have leases that refer to GAAP to have an understanding of the upcoming IFRS Standards; however, due to the complexity of GAAP and IFRS, it is suggested that costs recoverable under commercial leases should not be tied to GAAP, but spelled out in clear lease terms. For more information about the significant differences between IFRS and the existing CICA Handbook that may impact landlords, please read the full article below.