After a one-year deferral due to the pandemic, ASC 842 takes effect for private companies at the end of this year. So yes, there’s another deadline—and this time, thank the accountants. This new accounting standard published by the Financial Accounting Standards Board requires companies to track and disclose all lease obligations more consistently in their financial statements, including commercial real estate leases.
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 and important change for practically every lessee business owner. The main reason is that this is what accountants do—ensure consistency in comparing financial statements that reflects the substance of the business operations. Simply reflecting a monthly cash payment and rent expense doesn’t show the complete picture of the full lease term obligation, also 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. Accurately showing the full liability and simultaneous asset allows lenders, investors, buyers and sellers to easily compare financial statements across companies. 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 that off-balance-sheet obligations 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 full 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 jump in, there are a series of steps that are consistent for anyone adopting the new standard:
- Create a lease inventory
- Review current system and tech needs
- Test sample agreements
- Conduct an embedded lease search
- Train accounting management and leasing team
- Standardize disclosures and provide them to management
- 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.
Taj Adhav was a CPA for 15 years, with experience in the Big Four, and is now the founder & CEO of Leasecake, a location-management platform for tenants, landlords, and brokers who operate multiple locations with a distributed team.