The long-awaited deadline has finally arrived for private companies to adopt the new lease accounting standard, ASC 842, which changes how organizations account for leases. While the new standard might appear to be a simple change in the accounting rules, it is much more. It will impact how businesses operate, and it will require owners and operators of commercial real estate (CRE) to make significant changes to the way they do business. The effect will be magnified by the impact of hybrid work models on the office rental landscape.
Learning the complexities of the process and applying them without error will be no easy feat. With the number of leases CRE entities generally manage and hold, the standard could be uniquely complex to adopt for the sector. It may affect current arrangements with groups leasing properties from CRE.
Here's a look at how the new accounting standard may impact the CRE sector.
What Is ASC 842?
The Financial Accounting Standards Board (FASB) introduced ASC Topic 842, Leases to create more consistency between the accounting for companies with leases (lessees) and companies that manage leases (lessors). New requirements went into effect in late 2018 for public companies and, after several extensions, finally went into effect for most private companies for fiscal years beginning after Dec. 15, 2021.
Changes in the new ASC 842 lease accounting standard will require organizations to record all leases on their balance sheet, except for short-term leases. For lessors, this requirement isn’t the part of the standard that’s new, but it is a significant change for lessees. Prior to ASC 842, lessees recorded most of their leases off the balance sheet. Some companies in the CRE sector may be on the lessee side of an arrangement, but it is likely that the lessor accounting changes will be the most applicable to commercial real estate groups. The lessor changes included in ASC 842, while not as significant as the lessee changes, will still require advance preparation to implement.
How Will ASC 842 Affect CRE?
Among the biggest changes to lease accounting for lessors are the updates ASC 842 makes to the lease classification test. The new lease accounting standard changes definitions for leases and the process by which leases are classified for accounting purposes. A sales-type lease, for example, is no longer required to have selling profit or loss. Lessors can only have a direct financing lease if there is a residual value guarantee by an unrelated party that, along with the present value of the sum of lease payments (including any residual value guaranteed by the lessor), equals or exceeds the fair value of the underlying asset, all of which is probable of collection.
Lessors should prepare for expanded disclosure requirements under ASC 842 to provide more information on the nature of their leases and sub-leases. They will also be required to disclose how they manage the risk associated with the residual value of their leased assets.
The financial impact of ASC 842 adoption falls more on the lessee accounting side, but there may nevertheless be an impact on lessor-CRE groups. For example, the new accounting standard does not require short-term leases to be recorded on a balance sheet, which may lead to more lessees opting for short-term leases.
The CRE industry is already witnessing a decline in long-term leases, especially in the aftermath of the pandemic. Remote work is proving to be a cost-saving alternative to leasing unused space. Many companies favoring a hybrid work schedule may pursue short-term leases for smaller office spaces to meet flexible workplace demands. Now with the accounting standard change impacting financial reporting for lessees, traditional long-term leases may become even less prevalent. The evolving office rental landscape may also force landlords to accept more short-term leases to stay competitive; otherwise, they risk having to increase rent rates.
For More Information
ASC 842 has brought about significant changes for private companies and the CRE industry. While some challenges lie ahead for CRE entities in adopting the new standard, these challenges can be overcome with careful planning and execution. To be prepared for how ASC 842 may impact their business, CRE owners and operators should learn all they can about the new standard’s accounting changes and its implications for leases.
For assistance with the lease accounting adoption, please connect with a member of our complex accounting team.
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Published on January 25, 2022