ASC 842 Lease Accounting for Tenants and Landlords

The new lease accounting standards under ASC 842 were effective for private companies with a calendar year-end beginning January 1, 2022. These new standards require companies to record substantially all leases on their balance sheets and will affect real estate leases for both tenants and landlords. There will be a significant change for tenants, who under ASC 840 had mostly recorded their leases off balance sheets. Landlords will not be as significantly affected by these standards, but there are intricacies of which they should be aware.

Real estate leases have traditionally been recorded as operating leases, under which tenants record their rent payments as expenses and landlords record their rent receipts as revenue on a straight-line basis on their income statements. Under the new standards, tenants will record a right-of-use asset and a lease liability, initially measured at the present value of the lease payments, on their balance sheets. Tenants will then calculate interest on the lease liability and amortization of the right-of-use asset on their income statements to arrive at a straight-line lease expense.

The accounting for landlords will not substantially change under the new standards, except for accounting for some of the costs associated with obtaining a lease. Under ASC 840, costs associated with obtaining a lease were capitalized to the balance sheet and amortized over the life of the lease. Under ASC 842, the definition of initial direct costs changes. Initial direct costs are now defined as expenses that would not have been incurred if the lease had not been executed and will continue to be capitalized and amortized over the life of the lease (a commission to a broker, for instance). Initial indirect costs that are incurred whether the lease is executed or not are now just expensed as incurred. For example, legal fees incurred to negotiate a lease are going to be incurred whether the lease is ultimately executed or not. Under the new standards, these costs will be expensed as incurred.

One scenario that could have a significant effect on landlords is accounting for ground leases, in which the landlord is actually a tenant who is leasing the land upon which the building they own is situated. Accounting for ground leases will require the tenant to record the right-of-use asset and lease liability, which for ground leases could be a term as long as 99 years, resulting in a significant asset and liability recorded on the balance sheet. For most landlords, this could be the only right-of-use asset and lease liability on their balance sheets.

Another challenge that could affect both landlords and tenants is debt covenants. The significant increases in assets and liabilities from leases could result in lower liquidity and performance ratios and higher leverage ratios, which may result in failed debt covenants. Borrowers and lenders should begin conversations early to come to an agreement on how these metrics may impact their covenants.

Real estate landlords and tenants should also consider the effects of the lease accounting standards while negotiating their leases. The COVID-19 pandemic and remote work environment have already begun a push away from long-term leases. ASC 842 may be another push towards short-term leases. With an accounting policy election, lease terms of 12 months or less can be excluded from these lease accounting standards.

The new lease accounting standards only apply to financial statements reported under Generally Accepted Accounting Principles (GAAP). Many real estate companies report their financial statements on the income tax basis of accounting and, therefore, do not need to apply the new lease accounting standards.

Author: Laura Riso | [email protected]