What is ASC 842 in real estate?

What is ASC 842?

ASC 842 is a lease accounting standard that significantly changes how companies in the real estate sector recognize lease transactions on their balance sheets. It mandates the inclusion of almost all lease liabilities and corresponding assets, altering financial ratios and metrics crucial for real estate businesses, and introduces more stringent lease classification criteria and enhanced disclosure requirements, necessitating comprehensive adjustments in accounting practices and reporting for these companies. ASC 842 replaced ASC 840 to enhance transparency and comparability by requiring both operating and finance leases to be recorded on the balance sheet.

Some of the most relevant aspects of ASC 842 for the real estate industry include:

1. Lease Recognition on Balance Sheets: One of the most notable changes is the requirement for lessees to recognize almost all leases on their balance sheets. This means that entities must now include lease liabilities and corresponding "right-of-use" assets for operating leases, which were previously off-balance-sheet.
2. Definition of a Lease: ASC 842 provides a more detailed definition of what constitutes a lease. For real estate, this includes agreements to use a specified property. The standard requires an assessment of whether a contract contains a lease based on the right to control the use of the identified asset.
3. Lease Classification: While the distinction between finance (previously capital) and operating leases remains, the criteria for classifying leases have been updated. This affects the pattern of expense recognition in the income statement.
4. Lease Measurement and Presentation: The new standard also changes how lease liabilities and assets are measured and presented. For real estate companies, this could mean significant changes in the recognition of rental income and expenses.
5. Impact on Financial Ratios and Metrics: The inclusion of lease obligations on balance sheets can alter key financial ratios and metrics such as debt-to-equity ratios, which can impact loan covenants and other contractual agreements.
6. Disclosure Requirements: ASC 842 increases the disclosure requirements, providing more transparency around the lessee’s leasing activities. This can have implications for real estate companies in terms of data tracking and reporting.

Here's a simple table comparing ASC 840 to ASC 842, highlighting the implications for the economic life and fair value tests as well as specialized assets:

The implementation of ASC 842 requires substantial effort, especially for real estate companies with extensive lease portfolios. It affects not only accounting but also potentially lease negotiation strategies, information systems, and internal controls.