ASC 842: The Key to Optimizing Your Lease Portfolio and Weathering a Potential Recession

The past year has been challenging for many organizations, as the economic downturn brought high inflation, rising interest rates and market volatility. However, the implementation of ASC 842 may provide a silver lining amidst the uncertainty. By enabling companies to optimize their lease portfolio, ASC 842 can help executives make more informed resource allocation decisions and see significant cost savings.

The impact under ASC 842 of rising interest rates is generally limited to the initial recognition of new leases and accounting for modified lease agreements. However, adopting the new accounting standard can empower organizations to manage their lease portfolio better, ultimately helping them weather the storm. By leveraging the benefits of ASC 842 and embracing a forward-thinking approach to lease portfolio management, organizations can navigate the complexities of an unpredictable business landscape with agility and resilience.

How Do Interest Rates Impact ASC 842?

The new ASC 842 lease accounting standard mandates that organizations record all leases, except short-term ones, on their balance sheets. This fundamental shift aims to paint a more precise and transparent picture of an organization's financial standing and provide a deeper insight into its financial risks. When interest rates rise, however, it impacts the accounting for any new leases into which a business enters, as companies must use discount rates in calculating the initial lease liability.Discount rates are also used when accounting for lease modifications.

Public companies use an incremental borrowing rate (IBR) for their discount rate, which is affected by various factors, including credit rating, lease terms, interest rates and economic conditions. Interest rate volatility requires frequent adjustments to this rate. Those adjustments must be readily available to accounting teams to ensure the correct discount rates are applied to new leases or changes in the lease portfolio. Most private companies may elect to use an appropriate risk-free rate in lieu of the IBR.

Re-Strategizing Your Lease Portfolio

An unexpected benefit of ASC 842 implementation is that it allows organizations to reevaluate their leasing strategy and unlock significant cost-saving potential. One of the critical tasks associated with ASC 842 is accurately tracking down an organization's leases. This allows compliance with the new standard and enables informed decisions about its leasing strategy.

With this information at the organization's disposal, this represents an opportune moment to identify which leases are essential to business operations; which can be cut to reduce expenses; which have upcoming expirations and need to be renewed; and which are not worth pursuing. This level of insight can help organizations optimize their lease portfolio — a helpful strategy during interest volatility.

Some examples of leases that organizations may consider cutting include:

• Retail Space
• Equipment Leases
• Vehicle Leases
• Storage Space

Rethinking Your Real Estate Needs

When considering leases to cut, it's important to acknowledge that real estate leases make up a significant portion of an organization's lease portfolio. With the implementation of the new accounting standard, coupled with soaring interest rates and an increasingly prevalent hybrid/remote workforce, companies may want to reconsider their real estate needs. For companies rethinking their real estate lease footprint, the accounting implications of downsizing that footprint might be potentially center around lease abandonment and the possibility of subleases.

Rather than committing to long-term leases for larger spaces, many organizations are now exploring smaller spaces for shorter periods. According to a recent study, 70% of the 200 senior real estate executives surveyed indicated their organizations plan to expand their portfolio in 2023. However, 88% of these companies are only planning for physical space needs up to one year in advance. This marks a substantial increase from last year, when only 35% of companies reported seeking shorter leases. The shift could represent a response to ASC 842 implementation since short-term leases — generally 12 months or less (as defined by the standard) — are not required to be recorded on balance sheets. It could also shed light on the changing workspace needs as hybrid and remote work arrangements continue to gain prevalence.

Next Steps

Published on April 18, 2023