ASC 842 Long-term Lease Accounting
Long-term leases have a greater impact on financials, given they remain on the balance sheet for an extended period of time. When making contract renewal decisions for long-term leases, you may find yourself examining their impact on your balance sheet.
Renewal considerations for long-term leases
Generally, lease renewals involve exercising an option in a current contract or negotiating a new contract. When a contract includes a renewal option, you do not have to exercise it; instead, you can seek to renew the lease with new terms.
For example, you might choose to not exercise an upcoming renewal option on an existing long-term lease with a new five-year term and higher rent than the current market rate. Instead, you could try to negotiate a lower price or a shorter lease term that will limit your commitment to the higher rent.
Lately, more organizations have been negotiating their existing contracts to take advantage of lower market rates and/or shorten their lease term.
Best practices for long-term lease renewals
To avoid unfavorable renewals or last-minute month-to-month conversions, companies should start the lease renewal process early — ideally 9 to 12 months prior to lease expiration. This provides time to:
- Explore alternative leases
- Benchmark current market rates
- Negotiate more favorable terms
This is especially true for real estate leases, which are often long-term. Finding a new location and planning a move takes a lot of time and money. If you wait too long, or too close to the lease expiration, you could end up exercising an option you don’t want or changing to a month-to-month lease because there is too little time to move or to negotiate a new contract.
To avoid this, lease management software like Visual Lease can alert you about upcoming renewal deadlines and other critical dates. This is incredibly useful when planning next steps and making timely decisions.
ASC 842 Short-term Lease Accounting
Under ASC 842, the “short-term” lease designation can be applied to an entire class of leases rather than on a lease-by-lease basis. By electing this practical expedient, short-term leases do not need to be reported on the balance sheet. This and other practical expedients simplify the lease classification process and help organizations more easily adhere to the new lease standard.
That means when you are first classifying and entering your leases into a lease management system, you should decide up front whether all leases of a particular asset class will be designated as short-term leases. For example, you might decide to treat all real estate leases or all equipment leases (or a particular type of equipment, such as copiers) of one year or less as short-term leases.
If you elect to apply the short-term designation, all leases that are one year or less in duration will be handled as short-term leases, with no exceptions. If you choose not to elect the practical expedient, then all leases will be considered long-term regardless of their duration.
Short-term lease renewal challenges
Just like long-term leases, short-term leases can be renewed by exercising an option or negotiating a new contract. However, exercising an option or extending the length of a short-term lease is tricky because it can affect the “short-term” classification. Consider two common scenarios:
- Scenario 1: A one-year lease with a renewal option exercised three months before expiration extends to 24 months. This exceeds the short-term threshold and must be reclassified as a long-term lease.
- Scenario 2: A one-year lease renewed only at the end of the term may be treated as a new, separate short-term lease. In this case, an organization could occupy the same space for multiple years while recognizing successive short-term leases.
Because renewal timing impacts classification, organizations must track lease dates closely to avoid compliance issues. A lease management software such as Visual Lease makes it easy to set up fields for different asset classes (such as real estate and equipment) and select which (if any) should be treated as short-term leases. With all your lease information in the system, the Visual Lease platform can then automatically determine which leases meet the short-term lease criteria based on the designated asset classes and contract dates and properly report the expense.
ASC 842 Month-to-Month Lease Accounting
Sometimes organizations allow existing leases to become month-to-month to delay decisions about long-term commitments. Ideally, an organization would have a minimum number of these leases and manage them strategically — making a conscious decision to go month-to-month for a limited time only.
Why organizations use month-to-month leases
Organizations may have month-to-month leases because renewals were not completed on time or sometimes the organization does not have a good strategy for replacing month-to-month leases and ends up continuing them “by default” rather than by choice.
Accounting treatment under ASC 842
From an accounting perspective, month-to-month leases are generally treated as short-term leases, unless reclassified. To remain compliant, organizations must be able to:
- Update lease records quickly
- Track rent and holdover charges
- Report expenses accurately in disclosure reports
With Visual Lease software, you can change the status of a month-to-month lease at any time. Lease management and accounting software lets you easily modify lease information, change the commencement date and add a forecasted expiration date and other data to create a new schedule and calculations for month-to-month tenancy.
Visual Lease also makes it easy to track the dollars associated with a month-to-month lease, including any rent that applies during a holdover as well as straight-line rent expenses. The system can even identify month-to-month leases and show them as short-term lease expenses in disclosure reports.
Use lease lengths to your advantage
By understanding how the different lease terms are defined, you can more simply manage them in a strategic way.
Using a lease management software platform like Visual Lease allows your organization to strategically manage lease terms by:
- Applying consistent treatment to leases according to classification, asset class and any practical expedients that are elected
- Providing tools for creating, tracking, reporting and analyzing lease terms and costs
- Alerting decision makers about critical lease dates and deadlines for exercising lease options and renewals
With the right tools, organizations can make more informed decisions about when to commit to long-term agreements, use short-term flexibility, or strategically manage month-to-month leases.
Learn more about how to account for different lease terms from one of Visual Lease’s in-house experts. Check out our on-demand webinar Managing Short-Term, Long-Term and Month-to-Month Leases (and Everything in Between).