Just like crafting the perfect cake recipe, mastering lease accounting under the ASC 842 lease accounting standard requires precision, careful measurement, and a touch of finesse. Whether you’re navigating the world of leases for a bustling chain of restaurants or a trendy lineup of retail hotspots, this guide is here to ensure your financial statements rise as beautifully as a perfectly baked confection.
ASC 842 might seem as complex as creating a multi-tiered cake masterpiece, but fear not – we’re here to guide you through each layer of compliance. From sprinkling the essence of transparency over your balance sheets to icing the cake with comparability across the industry, ASC 842 is the recipe for enhanced financial reporting in the world of leases.
In this guide, we’ll break down the ingredients of ASC 842, explain how it’s baked into the financial standards, and dish out practical insights to help you navigate its implementation smoothly. So grab your apron, gather your accounting utensils, and let’s dive into the ultimate ASC 842 compliance journey tailored for lease accountants in the vibrant and flavorful worlds of restaurants and retail.
Get ready to whisk away any uncertainty, knead out the challenges, and emerge from this guide with a well-rounded understanding of how ASC 842 can be your secret ingredient to success. We’ll help you cook up some compliance magic that’s as satisfying as the last bite of a perfectly crafted cake.
If that’s the case, then we’re here to give you a high-level understanding of the standard, its business implications, and the steps you can take to facilitate a smooth transition from your previous method of accounting for leases.
If you’re unfamiliar with the new lease accounting standard, then we want to help you gain a working knowledge of the topic and help make the accounting easier. Because as a multi-unit operating with more than one leased location, your operating real estate leases are likely both a liability and an asset. And very soon, you’ll need to start reporting them on your balance sheet.
Not sure where to start? The following guide will walk you through some common pitfalls experienced by public and private companies, and how Lease Accounting tools like Leasecake can alleviate the pain.
So, without further ado, let’s preheat those ovens of curiosity and begin exploring the delicious intricacies of ASC 842 compliance! 🍰
What exactly is ASC 842?
If you have a lease, there’s a good chance you’ve heard of ASC 842. ASC 842 is a new FASB lease accounting standard that public companies adopted in 2019. Private companies were to implement ASC 842 after December 15, 2021, for the 2022 fiscal year to comply with Generally Accepted Accounting Principles (GAAP).
The implementation of ASC 842 was staggered based on the type of entity to allow companies time to adjust their accounting practices and systems to comply with the new lease accounting requirements. This new standard brought about significant changes in how leases are recognized and reported in financial statements, affecting the way companies account for lease assets and liabilities.
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.
Mike Jerman, CPA and partner at Hollywell Partners, 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 the private industry and started looking around, a lot of the banks weren’t up to speed on 842,” Jerman 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.”
How is ASC 842 different from previous lease accounting standards?
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.
Now with ASC 842, with that same theoretical five-year lease, 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.
These calculations don’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. The final 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
In the past, under ASC 840, the previous lease accounting standard, transactions associated with leases flowed through the profit and loss statement and touched the balance sheet through cash or deferred rent.
However, under ASC 842, nearly all of your leases of one year or more must be shown on the balance sheet simultaneously as a right-of-use asset and lease liability at the net present value (NPV).
It all comes down to how your lease obligations may be both an asset and a liability on your books – at the same time…! How can this be?
The new standard says a lessee’s obligation to make lease payments meets the definition of a liability, because it involves a present obligation that arises from a past event and the obligation is expected to result in an outflow of economic benefits. The “past event” arises when the lessee signs the lease and the lessor makes the underlying leased asset available to the lessee.
The “present obligation” arises because the lessee cannot typically avoid making the contractual payments.
Furthermore, the lessee’s right to use the underlying asset during the lease term meets the definition of an asset. Despite legally owning the asset, the lessor typically can’t use or even access the underlying asset without the lessee’s consent.
Why was ASC 842 implemented as the new lease accounting standard?
A primary motive behind the roll-out of ASC 842 is financial statement comparability. This new model makes it easier for lenders, investors, and others to compare one company to the next if the balance sheet reflects all liabilities.
While initially this new standard may not seem like a significant change, Jonathan Martin of Horne said otherwise. “This is probably the most impactful, most far-reaching standard in the past two decades if you think about how leases were accounted for,” Martin said. “There’s over $3 trillion of unrecorded impacts to financials that are missing from financial statements, so it is significant.”
Where previously, leases only affected a couple of balance sheet accounts, now there will likely be six or seven accounts on your balance sheet that need to be updated quarterly, if not monthly.
“The fact that this is the biggest change in accounting standards in over 20 years is a big deal,” Martin said. “It’s not very often that you can say that unless you’re talking about income taxes. But when it comes to compliance like this for private sector companies, it’s so important”.
How Does ASC 842 Impact Business Decisions?
ASC 842 considerably affects business decisions. For example, your accounting department will need to spend more time on the monthly closing process as accounting for ASC 842 is more time-consuming than accounting for ASC 840. These tasks may result in budgeting, staffing, or procedural changes.
Perhaps you track lease details using a spreadsheet. Unfortunately, this method won’t work well under the new standard, especially with multiple leases. It’s too difficult to remain in command of the volume of data and not lose track of details.
Additionally, ASC 842 will affect business decisions regarding liabilities. On the balance sheet, liabilities are often viewed as a measure of business health. Financial ratios are one of the main things examined when discussing loans or possible business transactions. Liabilities are not only connected to day-to-day operations for accounting purposes but are incredibly important to lenders and investors.
Loan covenants carry various restrictions, and a considerable liability on the balance sheet can potentially push you out of compliance with lenders. In addition, buy and sell transactions can also be affected by liabilities on the balance sheet, so both parties must understand the type of liabilities present.
10 Steps to Reaching ASC 842 Compliance
Although it is overwhelming to think about changing accounting processes, there is a way to achieve ASC 842 compliance. Get ahead of the process by contacting lenders, lawyers, and accountants to determine the impact this change will have on your business.
It is vital to have your ducks in a row to ensure a smooth transition. There are various items to consider, such as organizing lease documents, retaining complete rent schedules, determining interest rates for NPV calculations, and maintaining lease abstracts.
Many large publicly held companies have been forced to go through a complete reassessment of their lease rent schedules because they weren’t correctly abstracted. The accuracy of your financial status depends very much on the accuracy of those rent schedules.
No matter the size of your company, there are a series of steps that are pretty consistent for anyone adopting ASC 842. We’ve broken each one down below so you can tackle your ASC 842 compliance.
- Create a lease inventory
- Connect with your auditor
- Solidify your crucial policy decisions
- Look at material transaction components
- Review current system and tech needs
- Sample agreement testing
- Embedded lease search
- Train accounting management and leasing team
- Disclosures standardized and provided to management
Step 1: Create a lease inventory
The first step is to create a lease inventory, which is often one of the most significant challenges in the process. And it’s best to get ready now.
An incomplete lease inventory leads to omission of leases from computations and disclosures. It’s particularly important when there are variable lease terms and changes in future lease payments.
The initial measurement of lease-related assets and liabilities requires straightforward calculations. However, subsequent changes in lease payments that vary with a rate or index (e.g., rents that increase for changes in an inflation index) are accounted for differently.
As part of creating this inventory, you’ll have a standardized set of inputs:
- Tenant improvement allowances
- Rent schedule
- Renewal options
- Cost of debt you’re going to apply
Creating a lease inventory is a crucial initial step because you want to make sure you’re not revisiting it later on when you start making entries.
Bottom line: Make sure you conduct a thorough investigation of all your leases, requisite rent increases, and renewal options, while partnering with appropriate operations personnel to facilitate complete lease populations and sustainable lease accounting processes.
Pro Tip: Leasecake clients who seek an ASC842 solution avoid this pitfall by taking advantage of our streamlined lease onboarding wizard. With the easy-to-use interface, they quickly create a complete financial picture for their portfolio, including reporting and collaboration with outside CPA firms or an experienced internal accounting team.
“Leasecake has every bit of information we need for our accounting team, from all the key dates, rent amounts, and commencements to increases, renewal options, and expirations,” said Brian Dixon, Real Estate Director of Team Oney Brands, which operates 100+ Papa Johns, and QDOBA restaurants. “It’s remarkably efficient for our team — and it’s easy.”
Step 2: Connect with Your Auditor and Lender
Evaluate if you have any upcoming audits, loans, or other transactions to consider. Opening a conversation with your auditor is crucial so you can plan appropriately. While ASC 842 is a detailed standard, many nuances are still up for discussion concerning the practical application, even among the Big Four accounting firms. Besides your auditor, your lender needs to understand your policies to ensure you comply with loan covenants. Also, participants of any other significant business transaction should understand how ASC 842 affects the balance sheet.
Step 3: Solidify your crucial policy decisions
For example, decide what rate you want to use for the NPV calculation. Will you use the incremental borrowing rate, risk-free rate, or imputed rate? Many choose the risk-free rate, although some pick the standard imputed rate. The rate determined is one of the topics you need to discuss with your auditor. “Many people say, ‘you know what? We’re going to use a standard rate of X percent that’s imputed,’” Adhav said. “But you don’t want to get into the system of looking at each imputed rate across every lease because it’s going to cost you a lot of money.” Another critical policy to resolve is the preferred adoption date. A popular choice is January 1, 2022, although some have selected a year earlier. Once again, this is why it’s so important to have these discussions with your CPA.
Step 4: Look at material transaction components
Review whether your transactions have tenant improvement allowances and where you stand in applying them. Consider if you have lease repayments, early access, rent abatements, transaction fees, renegotiations, or early terminations. All of these items need to be considered when transitioning to ASC 842 and brought to your accountant’s attention.
Step 5: Review current system and tech needs
If you already follow ASC 840, consider the current accounts on your balance sheet that need to transition to ASC 842. Make sure you have your amortization schedules solidified and find out if your accounting cycle is a twelve or 13-month cycle. Make sure to consider your accounting periods through the lease expiring furthest into the future. You need to incorporate this information to forecast your leases, including any year-end resets going forward for ten, twenty, or more years.
Create a vision for what future lease processes will look like, and look through that lens to ensure you select a scalable software solution that takes into account company-specific requirements. If you’re a CFO and your CPAs don’t want to do all this in Excel, then you can use lease management software designed to help compliance. Then engage a strong project lead who will facilitate effective and timely communication across all stakeholders.
“That’s what Leasecake is here for,” said Jerman said. “They have built a very nice ASC 842 system for about 95 to 99 percent of all current leases out there. I think it would be a nice alternative to any of the bigger boys or doing it yourself.”
Ensure strong communication between company personnel and implementation consultants to help avoid delays, cost overages, and inefficient data conversion.
“I know without a doubt that I’m not missing anything in my role as a multi-unit operator,” said Tim Doktorski, the controller for 70+ Domino’s locations who uses Leasecake for his lease administration and accounting. “When I found Leasecake and discovered the software was designed specifically for the tenant side, I was absolutely elated that there was a solution designed for the tenant side.”
Step 6: Sample Agreement Testing
Once you’ve created a lease inventory and selected a platform, it’s important to test with a set of 25 to 30 key assumptions and critical pieces from that inventory. Take the data from leases back to your inventory and your inventory back to leases — to make sure you’re in really good shape.
Step 7: Embedded Lease Search
This is specific to accountants and anyone with an extensive lease portfolio that’s not standardized. There is the potential that you have the right of an asset embedded in another contract.
“If you have a number of non-standardized leases or contracts with customers in which you’ve given any control of an asset, either as a freebie or as a vendor, it can generate an embedded lease within that contract,” said Jerman.
It’s an esoteric situation, but it does happen, especially in big operations. So if you think you might be in that situation, it’s best to seek guidance from an expert.
Step 8: Training Your Team
You’ll want to make sure everyone across the board knows what you’re doing, where your leases come from, how they originate, and what templates are current. From there, ensure the financials are up to date, and you’ve got adequate disclosures for adoption. Then, after checking all those boxes, you can go ahead and start plugging numbers through and getting them in your financials.
There are multiple people or departments involved who will need to be trained, including:
- Customer service
- And, of course, the accountants
Step 9: Disclosures standardized and provided to management
Income statements are accompanied by a set of footnotes that provide additional information to help analysts understand how a company arrived at its numbers. Those footnotes can be hundreds of pages long as in an SEC document or as little as five to 10 pages in a private set of financial statements.
With the adoption of the new leasing standard, there will be different numbers in the current year than there were in the prior year. The footnotes will explain all that. So it’s essential to make sure those disclosures are assembled, standardized, easy to fill in, easy to track — and then given to management to make sure they’re on board with the disclosure.
Step 10: Adoption
When everything is standardized and tested, you should be able to plug and play — even when new leases come in. If you give the right general ledger account numbers to the system, you should be able to just pull the journal entries, review, and post.
Getting Started with Lease Accounting Software for ASC 842 Compliance
If you’ve chosen a lease accounting software solution (like Leasecake) and are ready to transition away from spreadsheets, there can be quite a few steps. Below we’ve outlined a simple 9 month plan to help you make progress and stay on track.
- Review software platforms and make a selection.
- Begin lease onboarding immediately upon selecting a platform.
- Sample agreement review and embedded lease search completed.
- Data conversion and implementation preparation activities to continue.
- Data conversion and cutover completed.
- Sample testing validation completed.
- Training of operations, accounting, and finance personnel
- Communicate closely with your accounting team and outside CPA firm to review the disclosure tables and footnote preparation and make a plan to finalize
- Review by management
Don’t Stress About ASC 842 — Leasecake Can Help
As daunting as it may be to organize all of this information to transition to ASC 842, you can turn to Leasecake for help. Where spreadsheets fall short, Leasecake offers a multidimensional solution for tracking your lease details and accounting with effective technology integrated with a strong team.
Leasecake allows your accountants, lawyers, and lenders to access your data for multiple location leases through one access point. Not only does Leasecake keep your data organized, but we help you comply with ASC 842 requirements and provide helpful reminders regarding critical dates and other items you may want to track.
With Leasecake, ASC 842 compliance is easy.
Schedule a free consultation to see if Leasecake is the right fit for your business, and we’ll review your lease management needs.