Accounting for Office Leases under ASC 842

By Elizabeth K. Lewis, CPA, Business Assurance & Advisory Services Manager

Update: On Wednesday, June 3, 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update 2020-05, which granted a one-year delay on the required implementation dates of the new lease and revenue recognition standards for certain entities.

ASC 842: Lease Accounting for Offices

The new lease standard is expected to increase the total assets and total liabilities of publicly traded companies by some $1.5 trillion each, of which $1.1 trillion would come from capitalizing existing off–balance sheet real estate leases.[1] We expect this impact to spread to privately held companies, including non-profits who lease office space for back office or administrative operations. While an office lease may be a company’s only lease, and the company may not be in the business of “owning real estate”, the right of use asset and liability will now be included on the company’s balance sheet.

There Are Three Key Inputs to Recognition:

1. Determine the lease term.

Ensure the lease commencement date is as defined in the lease agreement which may not be the same as the rent commencement date. Include any options to extend that the lessee is reasonably certain to take.

2. Determine the total payment amount. Specific consideration for office leases:

• Things to include:
  • Initial direct costs – commissions
  • Lease incentives received (reduces total payment amount)
  • Fixed payments required for tax and insurance
• Things to exclude:
  • Leasehold improvements (account for these consistent with superseded guidance)
  • CAM allocations required as part of monthly payments
  • Variable payments required for tax and insurance (reimbursements)
  • Legal costs associated with drafting or reviewing the lease agreement
  • Due diligence costs on the space

3. Determine discount rate.

Using the inputs above, the present value of the lease payments can be determined. In some cases, based on the term of the lease, the present value of the lease payments may be equal to or greater than the fair value of the real estate. The fair value can be determined through market research based on comparable sales in the geographic area. If the present value of the payments equals or exceeds substantially all of the fair value, the lease should be accounted for as a finance lease.

The majority of office leases do not contain a purchase option or the other criteria for qualification as a finance lease and primarily will be classified as operating leases under the new standard.

Office Lease Recognition (as an Operating Lease)

At lease inception, record a right of use asset and operating lease liability equal to the present value of future lease payments. Note the liability may increase in subsequent periods if there is a free rent period.

Next, create an amortization schedule by month (assuming a monthly payment schedule). Each month, two entries are required:

1. Record lease expense (debit) on a straight-line basis. Increase (credit) the lease liability by the interest component from the amortization schedule. Reduce (credit) the right-of-use asset by the difference in these 2 amounts.
2. Decrease (debit) the lease liability by the cash payment amount. Credit cash payment.

The net impact is to reduce the lease liability each month by the “principal” portion of the payment, recognize lease expense on a straight-line basis, and reduce the asset using the effective interest method over the term of the lease.  See example journal entries within the article linked here.

For financial statement presentation, the right of use asset and operating lease liability are not required to be separately stated on the face of the financial statements as long as they are disclosed within the notes to the financial statements.

Although the new standard will be valuable for certain companies and industries, the jury is still out on the usefulness of “grossing up” a company’s balance sheet for office leases. Hopefully the increased transparency of office lease liabilities will help inform users and aid management in decision making.

Questions on how the new lease standard may impact your business? We can help. Contact your Keiter representative or Email | Call 804.747.0000

Sources:

[1] Jeff Beatty, Ian Bilenness, Mile Nelson, Amie Sweeney, and Nick Tansey, “Revised Exposure Draft in Lease Accounting Issue: Back on Front Burner,” CBRE Global ViewPoint, June 2013