This is the first in a two-part series on the new lease accounting standard, ASC 842. It’s based on a webinar featuring Mike Jerman of Hollywell Partners and Leasecake CEO Taj Adhav. Click here to read the second post or here for a webinar replay.
After a one-year deferral due to the pandemic, ASC 842 goes into effect for private companies at the end of this year. This new accounting standard published by the Financial Accounting Standards Board (FASB) requires companies to track and disclose all leased assets — including commercial real estate leases.
So now, instead of just rent expense, and cash or a payable on your P&L, and then subsequently on the balance sheet as an AP amount, you’ll recognize both an entire asset and liability at the net present value for the entire lease term. The P&L treatment for operating leases effectively will look the same. But when someone looks at your balance sheet, they’ll have a corresponding asset and liability to measure against.
As a CPA and partner in Hollywell Partners, Mike Jerman has already been through the transition from ASC 840 (the previous standard) to 842 with public company clients. What he learned is that getting it right can take longer than many companies realize.
“As I got into private industry and started looking around, a lot of the banks … weren’t up to speed on 842,” Mike said. “So, this has been a big sticking point for rewriting bank agreements, getting covenants rewritten. You’re starting to have to do pro forma financials that show the before and after effect on a balance sheet. There’s quite a bit of prep behind this, to get it right the first time out. without it being a headache. Yeah, it will be a pain.”
The Evolution of Lease Accounting
Back in the day, it was simply a credit to cash. You wrote a check for your lease payment, and you recorded it as a rent expense or a lease expense. With ASC 840, we started trying to balance this off-balance-sheet obligation 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, irrespective of the rent bumps, and divided it out 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 will apply a present value calc, which is really your cost of debt, and recognize that full asset and liability. Then you break out the short- and long-term liabilities.
“If anyone else is picking up on this, what’s on the right [in the box above] really looks like a debt instrument,” Mike said. “Which, theoretically, if someone’s giving you terms … you technically do have a bit of a debt instrument.”
Mike went on to say this doesn’t change the overall EBITDA numbers. It’s simply an accounting treatment so everyone can have apples-to-apples lease comparisons on the balance sheet . But the ending bottom-line numbers don’t change.
What it all boils down to is this:
- You have an asset and a right to use that asset
- You have the counter as an offset liability
- Liabilities within the next year move from long-term to short-term