ASC 842 – A deeper look at the impact to operating leases

Revenue recognition

Under ASC 842, lessors will continue to recognize lease income as they did under ASC 840 (usually on a straight-line basis). The new standard changes how lessors recognize lease revenue for tenants where collection is no longer probable.

Leases where collection is not probable

Lessors should assess the collectability of each operating lease on an ongoing basis (including at inception of the lease). If, at any point during the lease term, collectability of the lease payments is not probable, the lessor would write off the tenant’s receivable balance (including the accumulated deferred rent receivable or liability) as a reduction to current period lease income.

Example A

ABC Tenant has a three-year lease that commenced on January 1, 2022, with contractual base rent payments as follows:

Year 1 - $1,000/month
Year 2 - $1,200/month
Year 3 - $1,400/month

The monthly straight-line rent recognized will be $1,200/month

In November of 2022, ABC Tenant stopped paying base rent and, in December of 2022, ABC tenant entered bankruptcy proceedings with the collection of lease revenue no longer probable. As of December 2022, ABC Tenant had outstanding base rent receivables of $2,000 and a cumulative straight-line rent receivable of $2,400. The lessor would account for this as follows:

Lease Income                               $4,400
Rent Receivable                           $2,000
SLR Receivable                            $2,400

Note: ASC 842 does not require rent receivable and SLR receivable to be separate. They are shown separately in the examples in this article for illustrative purposes only.

When payments are received (during the period when collectability is not probable), the lessor recognizes income as the lower of the payments received or the amount that would have been normally recognized on a straight-line basis.

Under the new standard lessors will no longer have a tenant-specific receivable reserve, however, a general reserve can still be maintained.

Example B

Same fact pattern as Example A. In February of 2023 ABC tenant paid $2,000 for the November and December past due rent. The lessor would account for this as follows:

Cash                               $2,000
Lease Income             $2,000 

Note that total cash received through February 2023 of $12,000 ($10,000 through October 2022 and $2,000 collected in February 2023) is less than the total of $16,800 that would have been normally recognized on a straight-line basis through February 2023 (14 months at $1,200/month). Therefore, the lessor recognizes lease income equal to the current cash received of $2,000.

Collectability concerns resolved

If at any point, the lessor determines that collectability of the remaining lease payments becomes probable, recognition of lease income reverts to the original accounting (usually straight-line basis) using the initial calculation (assuming the lease has not been modified). An adjustment is booked to current period income equal to the difference between cumulative income per the straight-line calculation and actual income booked to that point (catch-up adjustment).

Example C

Same fact pattern as Examples A & B. In March of 2023 ABC tenant resolved their bankruptcy and their collection of lease income is deemed probable. The lessor would perform the following analysis and adjustment in March:

The lessor compares what was recorded from the commencement of the lease through March 2023, to the amount that would have been recorded had collectability always been probable and records an adjustment for the difference in the current period.

Lease income per straight-line calculation:    $18,000 (15 months at $1,200/month)
Amount recorded                                                        $12,000 (Cash received to date)
Adjustment Required                                                  $6,000

The lessor would record the following entry:
Base Rent Receivable                            $3,600
SLR Rent Receivable                             $2,400
Lease Income                                           $6,000 

Accounting for lease-related costs

What can be capitalized under ASC 842?

Under ASC 842 lessors will continue to capitalize initial direct costs, however, ASC 842 has narrowed the definition. Under ASC 842, lessors can only capitalize lease costs that would not have been incurred if the lease had not been executed. This excludes certain costs that were previously capitalized under ASC 840, such as the cost of obtaining legal advice, negotiating lease terms, and evaluating a prospective lessee’s financial condition, despite the fact that they are incurred in connection with the new lease. The most common example of costs that can still be capitalized under ASC 842 are lease commissions. 

Transition considerations

Under ASC 842, a Lessor would be required to reassess all lease costs already capitalized prior to the implementation of ASC 842 to determine whether they meet the criteria for capitalization under the new standard. However, lessors may elect a practical expedient which allows them to avoid this reassessment and account for the change prospectively.

There are two conditions that must be met in order to elect this practical expedient:

• The lessor must also elect two other practical expedients stating that the entity need not reassess whether any expired or existing contracts contain leases, and that the entity need not reassess the lease classification for any expired or existing leases.
• The lessor must apply these practical expedients to all its leases, including those for which the entity is a lessee.

A disclosure should be added to the financial statements if this practical expedient is elected.

Financial statement presentation impact

Under ASC 842, lessors will have to identify the various components of each lease, which include both lease and non-lease components. They would be required to account for the lease components (such as base rent) under ASC 842 and non-lease components (such as CAM, insurance, and real estate taxes) under ASC 606. However, there is a practical expedient that lessors can elect, which would allow them to account for the lease and non-lease components as a combined single component under ASC 842.

As a result of electing this practical expedient, all lease payments (base rent and reimbursements such as CAM, insurance, and real estate taxes) will be presented as a single line item on the income statement, with a footnote disclosure presenting the breakdown of the fixed and variable payments.

When this practical expedient is elected, a disclosure should be added to the financial statements, the details of which are described in ASC 842-30-50-3A.

Mazars’ Insight 
While the focus around ASC 842 has been primarily on the impact to lessees, especially the changes to the balance sheet, there are impacts to lessors that need to be evaluated and considered for 2022.

Author: Akiva Levy and Yoni Block