For private companies, a new era of updated lease accounting standards is getting real. Better known as ASC (or Topic) 842, it impacts what is typically one of a company’s highest expenses and long-term obligations: commercial real estate leases.

For fiscal years beginning after Dec. 15, 2021, ASC 842 forces privately-held companies to more stringently account for the future costs of these leases on the balance sheet, an onerous change with a price tag that may seem shockingly high to the C-suite. As they begin to grapple with delivering the first financial reports under the new standards, many private companies are finding that the work involved in complying is more complicated than expected. “I’d be thinking about ways to accelerate the process,” said Joe Fitzgerald, senior vice president of lease market strategy with Visual Lease, a lease accounting software company.

At its core, under the new standards the Financial Accounting Standards Board (FASB) wants all companies to record operating leases longer than one year on their balance sheet, both as an asset and a liability, in the same way as capital leases have always been recorded. It is no longer permissible to only record operating lease expenses on the income statement and disclose future operating lease obligations in the notes to the financial statements. Financial statement users have long considered operating leases to give rise to assets and liabilities for lessees, so the logic goes that actually recording them on a companies’ balance sheet is a good thing for some stakeholders.

A complicating factor is that the Financial Accounting Standards Board (FASB) is poised to take another crack at updating a narrow part of the existing lease guidance related to lease accounting that would clarify how a parent and a subsidiary should determine whether a lease even exists that needs to be accounted for.

No reprieve likely but surprises are

But despite those changes on the horizon, it’s not prudent to count on a reprieve from the new rules. Public companies already made their transition, but for private companies, the requirement has already been extended twice due, in part, to complexities related to the COVID-19 pandemic. “Another delay seems unlikely at this point given the FASB’s unanimous decision against further delay only about 10 months ago,” said Scott Muir, a partner in the department of professional practice of KPMG U.S.

One potential hiccup for companies looking to implement ASC 842 for the first time is that the definition of leases is broad. According to KPMG, leases under this and the previous guidance (ASC 840) could include or be embedded in sales contracts, supply contracts, dedicated manufacturing capacity and ‘as-a-service’ contracts, arrangements that may not immediately come to mind when thinking about leases.

In a white paper, KPMG identifies cases where leases may unexpectedly exist or arise, such as from a shuttle service set on a corporate campus where the company pays a fixed fee each month for the services. “There’s a lot that goes into preparing for these changes,” said Renee Minchin, a former CFO now with 2account, a virtual CFO and bookkeeping company.

For professionals, the pressure is on: Not implementing this new standard correctly could result in increased audit fees and fines, potential legal action and less credibility. Visual Lease has found that a staggering 99% of senior and financial professionals acknowledge fears in potentially misrepresenting information. Fears include: increased audit fees and fines (51%), damage to a company’s credibility (49%), risk of legal action (48%), and damage to the professional’s own reputation (44%).

It doesn’t have to be this way. Here are six steps CFOs of private companies can take now to ensure a smooth transition to the new standard:

1. Complete lease inventory. Ensuring a complete lease inventory is something that may not be able to be done quickly. “Make sure you have all of your leases identified. Don’t wait until 2023,” Muir warned. “Take the opportunity now to make sure you have that complete lease inventory.” When it comes to embedded leases, companies need to think broadly about what will qualify, including those leases that may arise from unexpected or hidden lease items. “We’ve had customers that were surprised,” Fitzgerald said.“They found real estate leases they didn’t know they had.”
2. Consider aligning terms. When it comes to addressing leases between a parent and a subsidiary, making sure the lease and any improvements are on the same term is helpful, Fitzgerald said, adding that accounting treatment of leasehold improvements between the entities is complicated. “The question becomes how long to amortize the improvement, if the intercompany lease has a significantly different term than the leasehold improvement,” Fitzgerald said. “Aligning the two terms minimizes the impact of the question.”
3. Strengthen record keeping. Not every lease is identified as such, and many companies have decentralized paperwork processes. Work now to ensure you have all of your lease agreements and related records necessary to do the new accounting and make the new required disclosures.
4. Adjust staffing levels. Don’t underestimate the task. Ensure you have enough team members, and recognize that this is not only an “accounting” team task. Identifying leases and obtaining contracts and other records will often necessitate buy-in and assistance from legal, procurement, operations and other departments, Muir advised.
5. Consider needed changes. “The new rules can be complex, so it’s important to take the time to understand them fully,” Minchin said. “This way, you can determine how they’ll impact your specific leases and make any necessary changes.” Once you understand the new rules and how they’ll impact your leases, you can make any necessary changes. This may include renegotiating lease terms or altering your accounting methods, she said.
6.  Allow time for complications. Finally, as surprise leases emerge and the accounting becomes apparent, some companies are encountering issues that could create ripples leading all the way to such areas as debt ratings. “These changes may cause headaches with existing banking covenants and agreements,” one accounting firm noted. Once companies “dive in, they realize how complicated it is, not only on the accounting side, but on a practical implications side,” Fitzgerald pointed out.