Operations
Why operators should plan now for lease accounting compliance
After a one-year pandemic deferral, ASC 842 goes into effect for private companies at the end of this year. Yes, there's another deadline, essential for you and your accounting team
September 16, 2021 by Taj Adhav
After a one-year pandemic deferral, ASC 842 goes into effect for private companies at the end of this year. Yes, there's another deadline, essential for you and your accounting team. This new accounting standard published by the Financial Accounting Standards Board requires companies to track and disclose all lease obligations and assets in their financial statements more consistently — including commercial real estate leases. Complying with the new standard allows lenders, investors, buyers, and sellers to more easily compare financial statements across companies.
In a nutshell, ASC 842 requires tenant operators to bring most leases onto the balance sheet. So instead of just having a rent expense on your P&L and then subsequently on the balance sheet as a monthly deferred amount, you'll need to show the entire lease obligation for the duration of the lease term as an asset and a liability valued at the net present value. That's a huge number if you look at the total future payments of all your real estate leases, and it involves a series of complex conditions and calculations that may be daunting to your team.
This new standard is a significant but essential change for practically every lessee business owner – including any Franchisors leasing space for their corporate stores. The main reason is that accountants ensure consistency in comparing financial statements that reflect the substance of the business operations. Simply reflecting a monthly cash payment and rent expense doesn't show the complete picture of the entire lease term obligation, referred to as a liability. Simultaneously, an "asset" is recorded because operators have the right to use a location for the duration of the lease. Complying with ASC 842 provides a much clearer financial picture of the entire lease portfolio payment obligation, rather than just showing the current year rent expense and payment, which is how it all began.
Previously, it was simply a credit to cash. You wrote a check for your lease payment, and you recorded it as a rent expense. Then came the prior standard of ASC 840, which evolved into requiring off-balance-sheet obligations to be recorded into a system that provided a little bit of visibility.
If you had a five-year lease with rent bumps, ASC 840 drove a straight-line calculation. You took the total amount of those 60 months, including the rent increases, and divided it evenly. You booked your cash payment and your rent expense over time, but it created deferred rent so you would start to get some visibility — some normalcy.
With that same theoretical five-year lease under ASC 842, companies now need to apply a present value calculation, either the risk-free Treasury rate or your cost of debt, and recognize that total asset and liability. There's a series of tests to be applied to each lease for validation. From there, the monthly effort from your accounting team can be costly because you need to start the amortization of the lease payments, effectively breaking out the short- and long-term liabilities.
There's a lot of effort behind the scenes to get this right the first time — and it's essential to start now. If you want to get a head start, there are a series of steps that are consistent for anyone adopting the new standard:
1. Create a lease inventory.
2. Review current system and tech needs.
3. Test sample agreements.
4. Conduct an embedded lease search.
5. Train the accounting management and leasing team.
6. Standardize disclosures and provide them to management.
7. Choose your adoption date.
Preparing for ASC 842 might seem daunting. And based on the public companies that didn't manage the transition so smoothly — that's a valid concern. But like any big project, it's all about getting started and planning out the steps. Just don't ignore the looming deadline until it's too late. The sooner you start and the more thorough you are, the better off you'll be.
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