Last Updated on June 1, 2022 by Morgan Beard
The New Lease Accounting Changes
ASC 842 is completely changing lease accounting as you know it. These lease accounting changes impact processes for both finance and real estate teams. While the transition to ASC 842 will be a heavy lift. The new lease accounting standards do provide more transparency into an organization’s financial health.
That transparency allows auditors, c-suite, and investors to better understand an organization’s financial risks and opportunities. In fact, Deloitte estimates that $1 – 3 Trillion in lease liabilities are going onto the balance sheet with the adoption of ASC 842.
All organizations private, public, and nonprofit will need to update their business processes in order to gain compliance. So, strategic planning, team alignment, and technology are crucial to successfully adopting the lease accounting changes.
Transitioning from ASC 840 to ASC 842
Under ASC 840, only capital or finance leases were required on the balance sheet. Both the liability and assets associated with that finance lease were measured.
In comparing ASC 840 to ASC 842, the biggest fundamental change is the additional requirement of accounting for operating leases on the companies balance sheet. The lease accounting changes now drastically impact how organizations measure their lease portfolio.
Under the FASB issued, ASC 842, lessees must clearly represent their lease obligations and payments for those assets on the balance sheet. Not only are finance leases required but so are operating leases. These standards apply to real estate and tangible property like PP&E (property, plant & equipment).
The Definition of an Operating Lease
What is an operating lease? Well, in its simplest form, an operating lease is a contract that allows the use of an underlying asset without transferring the ownership rights of said asset to the lessee at the end of the contract term.
So, more of an organization’s contracts will need to be evaluated to identify embedded leases. Significant judgements are required in order to determine:
- A contract contains a lease
- Application of the practical expedients package
- The determination of the discount rate
Do note, that any lease less than 12 months (ie. short term lease) does not need to be accounted for. Once you have your lease classifications defined than you can work through lease measurements.
Measuring your Lease Liability and Right-of-Use Asset
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. A lease liability consists of the following:
- Monthly Lease Payments
- The Present Value of Lease Payments
- The Discount Rate
The lease liability calculation begins by taking the discount rate and using that to present value the the lease payments. If you’d like to learn more about How to Calculate the Present Value of Lease Payments – Excel blog post.
The ROU Asset outlines the lessee’s right-of-use to an asset of the duration or life of the lease. In order to calculate the ROU asset, you need the following:
- Initial Lease Liability
- Prepaid Lease Payments
- Any Initial Direct Costs
- Any Lease Incentives Received
Measurement of the lease liability and the right-of-use asset give your team the amortization schedule for a particular lease. In order to get to the fun calculations, you’ll need to unlock the data within your lease portfolio.
Data Powers the Lease Accounting Changes
The new standards begin with the quest to find, abstract, and understand your lease data. For organizations using legacy solutions or keeping contracts and leases printed in a file cabinet, the search for your data will be time consuming. But, it is the first necessary step towards compliance.
Under the old standards, only finance leases need to be tracked. Now that operating leases are included on the balance sheet, the search for those contracts is on. Agreements like a color printer or coffee machine that were not viewed as leases, very well may be leases. On the other hand, service agreements, like an office cleaning contract will continue to be just that, a service agreement.
Reviewing your business’s entire repository of lease and contract data will help get you organized for the transition. Having the data alone is not substantial enough.
Your organization will need a techstack that unlocks your data set and can forge the path to ASC 842 compliance. While calculating your lease liabilities and right-of-use assets in excel spreadsheet is feasible. It is not scalable, risk-free, or a smart use of your team’s time. Lease accounting and lease management software is created to enable the lease accounting transition.
How Finance & Real Estate Can Collaborate
Both real estate and finance teams have never had to collaborate more closely. Considering the technical, financial, and data-focused demands of lease management, organizations will need to allocate resources for support.
The lease accounting changes require teamwork from numerous parties. Including real estate, facilities, human resources, c-suite, IT, and of course 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. They typically work in a lease management software or a spreadsheet. So, as the finance team begins to navigate the lease accounting changes, sharing a single source of truth will be helpful.
Lease Accounting Software
Not all software is created equally. One thing is certain, transitioning away from spreadsheets and into an automated software solution is beneficial. It will eliminate human errors, mitigate financial statements risks, and save your team time in the long run.
There are legacy software solutions that are clunky to use, difficult to navigate, and only consider one stakeholder, the finance team. As we uncovered, the lease life cycle impact numerous internal and external stakeholders. Your best bet as a modern organization is to partner with a lease accounting solution provider that considers every part of the lease life cycle.
Shameless plug, Occupier was built so that brokers could sign a new lease deal with the real estate team. The lease administration team could then take that new lease and automate the tracking of critical data and expenses. Meanwhile, the finance team can work to ensure the new lease is in compliance with ASC 842. All of those calculations and decisions can be shared with your auditors and internal or external collaborators.
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.
Lease Accounting Implementation Best Practices
On average, it takes 4 – 6 months to fully implement ASC 842, according to Deloitte. So, first-and-foremost, 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 C-suite, Real Estate, HR, Legal, HR and Auditors. This is the biggest change that commercial real estate has seen. So, the demand to form a strong steering committee is strong. Bring auditors into the planning process early. They can assist in assumptions and judgements that have impacts on 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 vs. a service contract.
3. Partner with Software Solutions
Ditch the spreadsheet. The lease accounting changes represents a fundamental shift away from the manual spreadsheet mentality of the past. Fortunately, software is here to help. 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 operation. Define how you will onboard newly signed lease deals. Plan out your orgs communication expectations surrounding lease terminations, and modifications.
Your Compliance Roadmap
Transitioning to ASC 842 is an ongoing process. While it may feel like a one-and-done. We can assure you it is more complicated than that. In fact, an organization with 300 leases in their portfolio can expect an average of 230 events to track in one year.
For example, modifications to a contract could result in the creation of an embedded lease. Meaning that contract which was previously off-the-balance sheet, now needs to be accounting for on the balance sheet. Having a crystal clear understanding of the standard and ability to calculate changes will be important.
Effectively and seamlessly adopting the new standards requires strategic planning and vision. Tracking revenue contracts, evaluating contract modifications, and calculating present value through the lens of the new standards requires a committed due diligence team. It is an on-going process.
The key to a successful compliance journey is team collaboration, creation of sustainable business practices and implementation of a lease accounting software.