Last Updated on October 18, 2022 by Morgan Beard
The New Lease Accounting Changes – ASC 842
The Financial Accounting Standards Board’s (FASB) ASC 842 accounting standards represent a monumental lease accounting change. The new standards are already having a marked impact on processes for finance and real estate teams, with Deloitte estimating that up to $3 trillion in lease liabilities will be added to the economy’s balance sheet due to these rules.
Altogether, ASC 842 represents a set of significant changes in accounting for leased assets by both lessees and lessors. The new standards aim to provide more transparency around financial reporting for leasing transactions, allowing auditors, executives, and investors.
While this will bolster confidence and transparency on company balance sheets, such a significant accounting standards update represents an essential task for accounting teams in every industry.
Under ASC 840, the previous lease accounting standard, the disclosure requirements only required that capital or finance leases be recorded on the balance sheets – particularly the liability and assets associated with a particular finance lease. In comparing ASC 840 to ASC 842, the most significant fundamental change with the new standard is the additional requirement of accounting for operating leases on the company’s balance sheet. The ASC 842 topic makes off-balance-sheet leasing activities are a thing of the past.
This dramatically changes how public and private entities measure their lease portfolios. Under ASC 842, the lessee accounting model must represent their lease obligations and payments for both finance and operating lease assets on the balance sheet. The accounting treatments apply to real estate and tangible property like PP&E (property, plant & equipment). With this accounting standards codification, audit teams and financial statement preparers will have more transparency into the health of an organization based on their cash flow and the lessee’s financial obligations.
The Definition of an Operating Lease
In its simplest form, an operating lease is a contract that allows the use of an underlying asset without transferring the ownership rights of that asset to the lessee at the end of the contract term.
These changes will mean an organization’s contracts must be evaluated to identify embedded leases. Teams will need to assess and determine the following:
- Whether an agreement contains a lease
- How to apply a practical expedients package
- The lease discount rate
One thing worth remembering with ASC 842 is that any lease less than 12 months (that is, a short-term lease) does not need to be accounted for. Once you have evaluated the length and the three details above, you can work through your lease liability measurements.
Measuring your Lease Liability
Fundamental to lease accounting is the recognition of your lease liability and right-of-use asset. These two measurements shall be made at the lease commencement date and are the foundation to your journal entries. A lease liability calculation uses the following variables:
- Monthly lease payments
- The lease term (and if it encompasses the remaining economic life of the underlying asset)
- Discount rate for a lease (ie – the interest rate)
The lease liability calculation takes the discount rate and the lease period to calculate the present value of all lease payments made over the contract’s course. If you’d like to learn more about how to do this calculation, take a look at our blog post running through this process.
Measuring Your Right-of-Use Asset
The ROU Asset outlines the lessee’s right-of-use to an asset of the duration or life of the lease. To calculate the ROU asset, you need the following:
- Initial Lease Liability
- Prepaid Lease Payments
- Any Initial Direct Costs (incremental costs)
- Any Lease Incentives received
You then add the first three values together and subtract the last value to discover what your ROU asset is.
Amortizing Lease Liability and ROU Asset
The measurement of the lease liability and the right-of-use asset will allow your team to develop an amortization schedule for a particular lease, allowing you to declare accurate information concerning your lease costs on your income statement and balance sheet.
In particular, the asset amortization schedule for ROU can be calculated via a straight-line expense method that amortizes the asset consistently over time. This is particularly useful for balance sheet declarations, whether you’re a private company or a public company.
How Data Powers the Lease Accounting Changes
Successful adoption of ASC 842 depends on how well you can find, abstract, and understand your lease data. This is a challenge for organizations using legacy solutions or keeping contracts and leases printed in a file cabinet. For anyone who relies on manualized processes, the admin involved in the necessary compliance process will be extremely time-consuming.
This is particularly true given that operating leases are now included on the balance sheet, which means that the search for various contracts is now on. Agreements like a color printer rental or a coffee machine that were not viewed as leases at the time they were taken out may now be leases, meaning that you might have to work backward through disparate records to bring your lease accounting into ASC 842 compliance.
Reviewing your business’s entire existing lease and contract data repository will help get you organized for the transition. To achieve this, your organization will need a tech stack that unlocks your data set and can forge the path to ASC 842 compliance.
Calculating your lease liabilities and right-of-use assets in an Excel spreadsheet is still feasible. However, it is not scalable, risk-free, or smart use of your team’s time – it’s a manualized, repetitive, and risky way to go about a task that can and should be automated. Instead, you should consider dedicated lease accounting and lease management software to enable your transition to ASC 842.
How Finance and Real Estate Can Collaborate
In light of ASC 842, real estate and finance teams have never had to collaborate more closely. Considering lease management’s technical, financial, and data-focused demands, organizations must devote more resources to this challenge.
The lease accounting changes require teamwork from numerous parties, including real estate, facilities, human resources, executives, IT, and finance & accounting. Understanding the new standards is one challenge. But creating a cross-department synergy and steering committee is another effort.
The real estate team is the closest to operating leases and is thus one of the most significant obligations for lease classification and recording under ASC 842. As the finance team begins to navigate the lease accounting changes and the need to log operating and capital leases, sharing a single source of truth with the real estate team will be crucial to efficiency and compliance success.
Lease Accounting Software
Not all software is created equally. Transitioning from spreadsheets into an automated solution is a significant boost for teams. Along with radically reducing the risk of human error and mistakes on financial statements, automation also offers a marked cut in the time it takes to record lease accounting data. There are several considerations to weigh when road mapping the implementation process and accounting software partner.
It’s essential to pick a solution that fits the modern market. Many legacy software solutions are clunky, difficult to navigate, and hard to use outside the finance team. It would help if you also looked for a lease accounting solution provider that considers every part of the lease life cycle. Ideally, this solution should allow stakeholders across your organization to input and monitor data.
Shameless plug on our behalf: Occupier was built so brokers could sign a new lease deal with the real estate team. With Occupier, lease administration teams can then take that new lease and automate the tracking of critical data and expenses, while the finance team can work to ensure the new lease complies with ASC 842. Those calculations and decisions can be shared with your auditors and internal or external collaborators, improving transparency and reporting integrity.
Once you understand the lease accounting changes, you have found all your lease data and assembled your strike team. Then, you can work to start implementing the new lease accounting standards. To get started, check out our Lease Accounting Compliance Hub!
Lease Accounting Implementation Best Practices
On average, Deloitte estimates it takes 4 – 6 months to fully implement ASC 842. So you should ensure you give yourself more time than expected to start the transition.
The roadmap to lease accounting compliance is long. But, these best practices will help optimize your time and mitigate potential risks:
Ensure that your finance team leading the transition has buy-in and alignment from executives, Real Estate, HR, Legal, HR, and Auditors. Form a strong steering committee and bring auditors into the planning process early. They can assist in assumptions and judgments that impact your lease accounting calculations.
2. Build Better Processes
Use ASC 842 as an opportunity to build better lease management processes. If contracts and lease agreements were printed, signed, and left in a filing cabinet, then take the time to update your processes as an entire organization. Consider training programs that teach stakeholders how to identify a lease instead of a service contract.
3. Partner With Software Solutions
Ditch the spreadsheet. The lease accounting changes represent a fundamental shift away from the manual spreadsheet mentality of the past. Evaluate software partners who can assist in automating and calculating your lease accounting operations.
Ensure your lease accounting processes are repeatable and trackable so auditors and new accounting team members can replicate the function. Define how you will onboard newly signed lease deals. Plan out your organizational communication expectations surrounding lease terminations and modifications.
Your Compliance Roadmap
Transitioning to ASC 842 is a long-term process. While it may feel like a one-and-done procedure, we can assure you that it will require your team to overhaul how they review and handle leases. For example, modifications to a contract could result in an embedded lease, bringing contracts that were previously off-the-balance sheet onto it. An organization with 300 leases in its portfolio can expect an average of 230 events to track in one year under ASC 842.
ASC 842 compliance breaches are a substantial risk among your team unless you have the right software or processes. It’s unrealistic to expect people to remember and manually log their operating leases. Ultimately, organizations require software and techniques to streamline the recording, communication, monitoring, and calculation of your lease ecosystem,
Effectively and seamlessly adopting the ASC 842 standards requires strategic planning and vision. This involves tracking revenue contracts, evaluating contract modifications, and calculating present value through the lens of the new standards requires a committed due diligence team.
ASC 842 compliance has to be treated as a change in processes. And the key to successful new compliance processes is team collaboration and best-in-breed lease accounting software.