November 28, 2018
When the clock strikes midnight on Dec. 31, not only will we usher in a new year, but we will also enter the beginning of a new era in lease accounting with the implementation of ASC 842. Starting in 2019, leases will be reflected on the balance sheet of public U.S. companies, followed by private companies in 2020.
While much of the effort since ASC 842’s passing has been on compliance, many corporations have switched their focus to the size of the obligations being added to their balance sheets. Why the concern? After all, the overall economics of the leasing contract did not change, and, in the U.S., the expense recognition pattern for operating leases under the new standard did not change. Rather, it is the sheer size of the assets and liabilities joining the balance sheet that landlords and tenants need to address.
For example, the International Accounting Standards Board estimated that public companies would add around $3.3 trillion of liabilities at the adoption of ASC 842. If you add private companies to that estimate, it is reasonable to anticipate $5 trillion of liabilities will be added to American corporate balance sheets during the next two years.
In the face of this issue, many companies have come to the realization that they need to reduce the balance sheet impact of the lease liabilities and related lease assets. Below are some strategies businesses may elect to follow to accomplish this objective.
- Shorten Lease Term: This is the simplest approach to reducing the lease liability. Shorter lease terms mean less liability to be recorded. However, this approach is not without risk, as shortening lease terms could expose companies to more frequent rent increases or the possibility of another tenant leasing their space from under them. Tenants should not rely on contract options to extend their lease, because the new standard requires that the lease liability calculation include options that are likely to be executed.
- Reduce Leased Space: Cutting the amount of space a company leases could take many forms, including optimizing current space configurations or reducing the number of satellite offices. The proliferation of coworking spaces may benefit businesses that want to maintain a smaller office or satellite locations by allowing for short-term leases that may not have to be recorded.
- Change the Lease Type: Most companies that rent office space do so using a gross lease, which includes all of the owner’s cost of ownership, such as taxes and insurance. Using a net lease would reduce a company’s liability because the ownership costs are billed to the tenant separately from the base lease, and thus are would not be included in the lease liability calculation. Although many companies typically avoid the variability of costs under a net lease, using this structure could reduce the liability of current office space up to one-third or more.
Some business leaders may not be concerned with lease liabilities because they either have no debt or have few outside users of their financial statements. These companies can take advantage of the changes by signing long-term leases, which landlords may view more favorably in the face of other tenants shortening lease terms or reducing space.
Whether a company is planning to reduce overall lease liabilities or not, savvy business leaders should partner with a trusted real estate advisor to navigate the rule changes and develop a strategy to adapt to this new lease accounting era.
– By Mike McLain, Chief Accounting Officer, Houston, TX.