Last Updated on August 3, 2023 by Morgan Beard
Since the implementation of ASC 842 by the Financial Accounting Standards Board, companies are actively looking for lease options with greater flexibility. ASC 842 guidelines account for calculating leases differently depending on lease length, causing short-term leases to soar in popularity. However, not all leases are short, and under ASC 842 it’s imperative to understand lease calculations for short- and long-term leases and leases paid on a month-to-month basis.
Lease lengths defined under ASC 842
Most companies must conform to ASC 842 guidance, so it’s helpful to understand how this lease accounting standard defines each type of lease:
- Short-term leases: Leases that last up to 12 months.
- Long-term leases: Leases that are at least 12 months + 1 day in length.
- Month-to-month leases: A month-to-month lease varies in definition depending on the type of lease (such as office space or equipment rental) and the laws of the state in which the rental property is located. Legally, this type of lease is exactly as you might think: the lease ends and renews every 30 days. When accounting for this lease type, the primary conditions are:
- Unlike a lease with a one-year or longer duration, month-to-month leases have no expiry date.
- Both the tenant and the landlord have the right to cancel the lease if desired.
- Embedded leases: Contracts that contain a right-of-use assets where the lessee has control over the underlying asset for a specified period of time. Embedded leases can fall into the short-term, long-term, or month-to-month category.
Accounting for long-term leases under ASC 842
A long-term lease has accounting implications on a company’s financial statements much greater than a short-term or month-to-month lease because the figures are carried forward each month on the business’s balance sheet. Near the end of a long-term lease, you might consider reviewing how it’s impacted your financial statements before you decide to renew. Under ASC 842, your ROU asset and lease liability is measured on your balance sheet.
Renewing a lease typically means either:
- Exercising your rights from your current lease that allows for renewals
- Reviewing the current lease’s terms and proposing changes or updates in the form of a new lease at the end of your current term.
If your current lease offers the option to renew, it’s not mandatory. Instead, request a lease renewal with your necessary term updates.
For instance, say you have a current long-term lease up for renewal soon and the lease includes a renewal option for the same term length as the current lease but with rent payments coinciding with the then-current market rates—this typically means your rental payments will increase. Instead of exercising your renewal option, you can either request a short-term lease going forward or stick with the long-term lease at a lower monthly payment.
Most commercial rental properties keep rents in line with current market conditions, which means that rental payments, while locked in during a lease term, usually increase at the end of a term. However, it’s not out of the question to:
- Request a lease renegotiation and lower payments if current market rates have dipped below your current payment
- Ask to update your current lease term to a shorter lease
Before you jump into negotiations, it’s best to know how calculating leases will play a role and the best practices to follow to ensure your organization remains in compliance with accounting standards.
Best practices for long-term lease renewals
Long-term commercial leases are typically five to 10 years in duration. You might think it’s early, but when your lease has nine months to one year remaining, that’s the perfect time to start the renewal process. By starting early, you can spend time reviewing other types of leases, gauge future market rates, and predict the most apropos rates for your business. Arming yourself with this information early puts you in the driver’s seat come renegotiations.
This is nowhere truer than with long-term commercial property leases. For example, say you wait till the last minute to do your research and begin discussing options. If you can’t reach an agreement with your landlord, you need to find a new business location. Planning and funding a household move is difficult—planning and funding a company move is downright expensive and time-consuming. Waiting too close to the lease expiry leaves little time to find a new location or discuss updating your lease options should you need to—which could mean accepting less-than-favorable lease conditions or opting to swap your long-term lease for a month-to-month lease.
Short-term lease accounting under ASC 842
Thankfully, you can opt to apply short-term lease classification lease classes—not just individual leases—under ASC 842. This allowance is known as a practical expedient. Practical expedients, as their name suggests, help streamline the accounting processes for calculating leases under the new guidance. These expedients help companies easily meet ASC 842’s compliance regulations.
So, when you’re first setting up your books under ASC 842, take the time necessary upfront to decide which asset classes’ leases you’ll classify as short-term (provided they meet the rules in the guidance for practical expedients). You could choose to handle all real estate or office equipment leases with durations up to 12 months this way. The benefits are two-fold: not only does this make your accounting department’s job a bit easier, but these leases do not have to be carried on the balance sheet.
Short-term lease renewal challenges
A short-term lease carries the potential for renewability, just like a long-term lease. Language is built into your lease that outlines your renew options. If you choose not to renew your expiring lease, you can opt to renegotiate your current lease’s terms in the form of a new lease. However, ASC 842 makes it difficult to exercise options or lease extensions for short-term leases—an option or extension could alter the lease’s short-term designation.
Here’s an example:
You’re in the midst of a 12-month lease that offers an option to renew. Nine months into the lease, you decide to renew for another 12 months. You still have three months remaining on the current lease and it’s classified as short-term. Once you sign your renewal paperwork, you have an additional 12 months of occupancy, meaning your lease now provides you the right of tenancy for 15 months—it’s now a long-term lease and no longer qualifies for practical expediency.
Calculating leases for long-term requires leased asset identification, a liability determination, and inclusion on your company’s monthly balance sheet.
But what if you wait until the expiration of your current lease and then renew? The lease would require long-term designation, right? We established the issues associated with last-minute lease renewals above. However, in this case, it’s actually advantageous to wait. ASC 842 includes no guidance in this respect, but it’s generally accepted that, should you renew a 12-month lease for a further 12 months at the completion of the previous 12 months, you could theoretically renew this short-term lease in perpetuity, and it becomes a new short-term lease.
ASC 842 month-to-month lease accounting
Sometimes it’s difficult to make commitments when a company’s future is unknown, unstable, or otherwise unpredictable. In these situations, a business might allow an existing lease to expire and renew it on a month-to-month basis. It’s best to minimize the number of these types of leases and ensure they’re strategically managed. When you choose to switch to month-to-month, you should also decide at that time how long you’ll continue renewing monthly—because this type of lease presents instability for an organization, it’s best to limit the number of monthly renewals and transition to a short- or long-term lease as soon as it’s feasible to do so.
On the other hand, some companies are transitioned into a month-to-month lease by the landlord for neglecting to renew in a timely fashion. Other times, a business just might not know how to strategically transition into a short- or long-term lease successfully and month-to-month becomes the default method rather than a conscious decision.
Calculating leases under ASC 842 with Occupier
You have so many responsibilities as a business owner — tracking lease obligations doesn’t have to be one of them. Occupier’s lease accounting software automates the entire lease accounting process, helping your organization comply with the standards set forth in ASC 842. Your lease accounting team is busy — between tracking operating expenses, triple checking lease commencement dates, exporting monthly journal entries and lease amortization schedules, all in accordance with new accounting compliance standards.
With Occupier, your team can save 50% of time on lease accounting tasks and trust you’ll pass our annual audit. Schedule a demo to learn about our dedication to your organization’s lease accounting responsibilities.