Lease accounting standards are bound to change over time as regulatory bodies seek to identify potential issues and create solutions to them. However, these changes may prove to be disruptive for companies in the short term. Take, for example, the FAS 13 / ASC 842 lease accounting standard that went into effect for most publicly-traded companies at the beginning of 2019.
The process of moving their books over to the new method for lease accounting – which required most operating leases to be treated as on-balance sheet capital items – caught many CFOs unaware and turned out to be more complicated and time-consuming than many of them projected. The challenges came in three areas – accounting for the leases, finding every lease, and dealing with how the new reporting impacted perceptions of their companies.
Lease Accounting Under ASC 842
Before the ASC 842 revisions to lease accounting, companies could choose to treat leases as on-balance sheet capital leases or as off-balance sheet operating leases. Most chose the off-balance sheet treatment, which left US company financials very different from the rest of the world. The FAS 13 / ASC 842 standard requires essentially every lease with a duration of over one year to be put on the balance sheet.
Now, companies have to look at their leases and make two entries. In their assets, they record an asset for the right of use that the lease grants them. They also create a liability for the lease payments that they are required to make. Separating out the right of use portion of the payment from the financing cost, determining the length and value of the lease in the face of renewal options or variable payments, and other factors have made this process more complicated than many CFOs expected.
Finding Every Lease
ASC 842 also expanded the definition of a lease. Every lease that a company takes out with a term of over one year needs to be accounted for. Airplane leases, real estate leases, equipment leases and the like are easy to track down. However, the new lease accounting standard also requires companies to put their "embedded leases" on their balance sheets.
An embedded lease occurs when a company gains control over a specific asset even if they aren't technically leasing it. One example could be an agreement with an IT provider that installs a server for the use of the company. If that server is intended to stay in place with the company having the benefit of that server, though, the service contract could actually be considered a lease. This would require it to be placed on the balance sheet. Due to this change, many companies have found it challenging to identify everything they are leasing.
Reaction to Revised Balance Sheets
On the whole, financial markets have spent the bulk of 2019 responding calmly to the creation of new liabilities and assets for companies that have leases in place. However, not every balance sheet revision has occurred without comment. Some companies have faced additional scrutiny when their debt levels – at least on paper – have skyrocketed due to the accounting standard changes.
(Private) Companies Preparing for ASC 842
As private companies move towards using ASC 842 / FAS 13 for their reporting at the beginning of 2021, paying careful attention to the pitfalls that many public company CFOs have encountered can help them to have a smoother implementation experience.
Delay in the FASB Commercial Lease Accounting Effective Date
Over the last couple of years, the Financial Accounting Standards Board has been in the process of putting Accounting Standard Codification 842 – the new lease accounting standard – into place. Its implementation has been long in coming and has proven to be more complicated than many accounting professionals expected. While it potentially affects every lease that a company holds, its impact is particularly pronounced on companies that extensively use leased commercial real estate space.
When ASC 842's new lease accounting requirements hit, public companies in the United States had approximately $3 trillion in liabilities added to their balance sheets overnight. While this change did not significantly impact net incomes or tax liabilities, it did greatly complicate accounting for many of these entities.
These requirements were originally scheduled to go into effect for most private companies that follow GAAP at the beginning of 2020. Because the transition to ASC 842 has proven so complicated, though, the American Institute of Certified Public Accountants (AICPA – the trade organization for accountants) sent a letter to the FASB to request a delay in the implementation of ASC 842.
The FASB unanimously voted on July 17, 2019 to grant this delay. The delay gave private companies an additional year to implement ASC 842. Beyond just giving private companies more time to comply, this delay also allowed them to learn more from what publicly-traded organizations do vis-a-vis their lease accounting.
Why is ASC 842 a Challenge to Implement?
Because ASC 842's definition of a lease is so broad, it has required companies to go beyond just looking at obvious items – like real estate and capital equipment leases – to find direct and embedded leases in documents like service agreements. This process has proven to be arduous and time-consuming.
The impact of the ASC 842 / FAS 13 lease accounting standard in the publicly-traded world has been significant for accounting teams without having great impacts on how those companies actually operate and perform. While it is likely that this will remain the case for private companies, an extra year of time to implement the standard could make the impact on their accounting teams more gentle.
Effective lease administration can help companies of all sizes to overcome the challenges of ASC 842 / FAS 13. The following section will highlight some of the numerous benefits of lease administration.
5 Reasons Why Lease Administration Benefits Corporate Accounting
Before reading on, it’s important to understand that lease administration is not simply an expense. It's an opportunity! Done correctly, lease administration can create opportunities to both reduce expenses and grow capital investments. Here are the top five ways that lease administration can help a company's bottom line:
1. Identifying Negotiating Opportunities
Combining lease information with market research gives your company a negotiating advantage with landlords. For instance, if a company offers to lock in a renewal at the same time that a building or its surrounding market is experiencing vacancy issues, they can usually achieve lower occupancy costs through rent reductions or through other landlord concessions. Knowing when payments are due also reduces the risk of missing important dates or disrupting corporate real estate staff's workflow.
2. Preventing Overcharges
Leases are complicated documents. Calculating rents, increases, CAMs and reconciliations is rarely a simple task. Furthermore, many companies have unique spaces with different lease terms and different underlying legal documents. Careful lease administration ensures that landlords don’t overcharge. It’s also important to avoid mistakenly under-paying CAMs, or else it could result in an unexpected reconciliation bill. Understanding lease documents and calculating what payments should be can help to find and fix such issues before they get too expensive.
3. Identifying Underutilized Properties
Utilization of all properties is a key part of lease administration. Whether it's a warehouse with 9% utilization, a retail location that does so few sales that the rent is equal to 15% of total revenues, or an office with more empty cubicles than full ones, a good lease administrator will identify the problems with spaces. Once lease admins know which properties are underutilized, they can begin formulating a strategy to adjust property portfolios accordingly.
4. Enabling Portfolio Size Adjustments
Lease administration data forms a strategic road map for adjusting a property portfolio. Spaces that are highly productive or have too many employees per square foot can be quickly targeted for expansion. Or, some spaces may need to be reduced in size or removed to increase efficiency.
Given the amount of time it can take to sublease a space or amortize the cost of an early lease buyout, identifying these issues quickly can give companies enough time to take action and protect their bottom line.
5. Identifying Acquisition Opportunities
Sometimes, lease administration turns into property management. Profitable sites with a long history of positive operation and the flexibility to accommodate the business' changing needs may be best handled as owned space instead of leased space. If a company uses software to import market data, it can identify those markets where the price to purchase space is lower than the cost of renting it and move forward with an acquisition.
Contact us to learn more about how lease administration can improve your corporate accounting and your bottom line. We are experienced commercial tenant representatives and developers of software that helps our clients leverage lease data and data in their markets to make better real estate decisions.
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