Since the implementation of ASC 842 by the Financial Accounting Standards Board, companies are actively looking for lease options with greater flexibility. ASC 842 guidelines account for calculating leases differently depending on lease length, causing short-term leases to soar in popularity. However, not all leases are short, and under ASC 842 it's imperative to understand lease calculations for short- and long-term leases and leases paid on a month-to-month basis.

How does ASC 842 define short-term, long-term, and month-to-month leases?

Under ASC 842, short-term leases last up to 12 months, long-term leases are 12 months plus one day or longer, and month-to-month leases renew every 30 days with no fixed expiry date and can be cancelled by either party.

• Short-term leases: Leases that last up to 12 months.
• Long-term leases: Leases that are at least 12 months + 1 day in length.
• Month-to-month leases: A month-to-month lease varies in definition depending on the type of lease (such as office space or equipment rental) and the laws of the state in which the rental property is located. Legally, this type of lease is exactly as you might think: the lease ends and renews every 30 days. When accounting for this lease type, the primary conditions are:
  • Unlike a lease with a one-year or longer duration, month-to-month leases have no expiry date.
  • Both the tenant and the landlord have the right to cancel the lease if desired.
• Embedded leases: Contracts that contain a right-of-use assets where the lessee has control over the underlying asset for a specified period of time. Embedded leases can fall into the short-term, long-term, or month-to-month category.

How are long-term leases accounted for under ASC 842?

Long-term leases must be recognized on the balance sheet as ROU assets and lease liabilities each month, making them the most financially significant lease type for financial statement purposes under ASC 842. Near the end of a long-term lease, you might consider reviewing how it's impacted your financial statements before you decide to renew. Under ASC 842, your ROU asset and lease liability is measured on your balance sheet.

Renewing a lease typically means either:

• Exercising your rights from your current lease that allows for renewals
• Reviewing the current lease's terms and proposing changes or updates in the form of a new lease at the end of your current term.

If your current lease offers the option to renew, it's not mandatory. Instead, request a lease renewal with your necessary term updates.

For instance, say you have a current long-term lease up for renewal soon and the lease includes a renewal option for the same term length as the current lease but with rent payments coinciding with the then-current market rates—this typically means your rental payments will increase. Instead of exercising your renewal option, you can either request a short-term lease going forward or stick with the long-term lease at a lower monthly payment.

Most commercial rental properties keep rents in line with current market conditions, which means that rental payments, while locked in during a lease term, usually increase at the end of a term. However, it's not out of the question to:

• Request a lease renegotiation and lower payments if current market rates have dipped below your current payment
• Ask to update your current lease term to a shorter lease

Before you jump into negotiations, it's best to know how calculating leases will play a role and the best practices to follow to ensure your organization remains in compliance with accounting standards.

What are the best practices for renewing a long-term commercial lease?

Real estate and finance teams should begin the long-term lease renewal process nine to twelve months before expiration to allow time to review market rates, evaluate alternative spaces, and negotiate from a position of strength rather than urgency. By starting early, you can spend time reviewing other types of leases, gauge future market rates, and predict the most apropos rates for your business. Arming yourself with this information early puts you in the driver's seat come renegotiations.

This is nowhere truer than with long-term commercial property leases. For example, say you wait till the last minute to do your research and begin discussing options. If you can't reach an agreement with your landlord, you need to find a new business location. Planning and funding a household move is difficult—planning and funding a company move is downright expensive and time-consuming. Waiting too close to the lease expiry leaves little time to find a new location or discuss updating your lease options should you need to—which could mean accepting less-than-favorable lease conditions or opting to swap your long-term lease for a month-to-month lease.

How are short-term leases accounted for under ASC 842?

Short-term leases qualifying for the practical expedient under ASC 842 do not need to be recognized on the balance sheet, simplifying accounting and reducing reported lease liabilities for leases of 12 months or fewer. This allowance is known as a practical expedient. Practical expedients, as their name suggests, help streamline the accounting processes for calculating leases under the new guidance. These expedients help companies easily meet ASC 842's compliance regulations.

So, when you're first setting up your books under ASC 842, take the time necessary upfront to decide which asset classes' leases you'll classify as short-term (provided they meet the rules in the guidance for practical expedients). You could choose to handle all real estate or office equipment leases with durations up to 12 months this way. The benefits are two-fold: not only does this make your accounting department's job a bit easier, but these leases do not have to be carried on the balance sheet. 

What challenges arise when renewing a short-term lease under ASC 842?

Exercising a renewal option or extension mid-term can convert a short-term lease to a long-term lease under ASC 842, triggering balance sheet recognition that would not have been required under the original short-term classification. If you choose not to renew your expiring lease, you can opt to renegotiate your current lease's terms in the form of a new lease. However, ASC 842 makes it difficult to exercise options or lease extensions for short-term leases—an option or extension could alter the lease's short-term designation.

Here's an example:

You're in the midst of a 12-month lease that offers an option to renew. Nine months into the lease, you decide to renew for another 12 months. You still have three months remaining on the current lease and it's classified as short-term. Once you sign your renewal paperwork, you have an additional 12 months of occupancy, meaning your lease now provides you the right of tenancy for 15 months—it's now a long-term lease and no longer qualifies for practical expediency.

Calculating leases for long-term requires leased asset identification, a liability determination, and inclusion on your company's monthly balance sheet.

But what if you wait until the expiration of your current lease and then renew? The lease would require long-term designation, right? We established the issues associated with last-minute lease renewals above. However, in this case, it's actually advantageous to wait. ASC 842 includes no guidance in this respect, but it's generally accepted that, should you renew a 12-month lease for a further 12 months at the completion of the previous 12 months, you could theoretically renew this short-term lease in perpetuity, and it becomes a new short-term lease.

How are month-to-month leases handled under ASC 842?

Month-to-month leases present accounting instability and should be minimized in a portfolio. When a company transitions to month-to-month, it should define upfront how long it will continue renewing monthly and plan to move to a short-term or long-term lease as soon as feasible. In these situations, a business might allow an existing lease to expire and renew it on a month-to-month basis. It's best to minimize the number of these types of leases and ensure they're strategically managed. When you choose to switch to month-to-month, you should also decide at that time how long you'll continue renewing monthly—because this type of lease presents instability for an organization, it's best to limit the number of monthly renewals and transition to a short- or long-term lease as soon as it's feasible to do so.

On the other hand, some companies are transitioned into a month-to-month lease by the landlord for neglecting to renew in a timely fashion. Other times, a business just might not know how to strategically transition into a short- or long-term lease successfully and month-to-month becomes the default method rather than a conscious decision.

How does lease management software help with ASC 842 lease calculations?

You have so many responsibilities as a business owner — tracking lease obligations doesn't have to be one of them. Purpose-built lease accounting software automates balance sheet recognition, journal entry generation, and amortization schedules for all lease types under ASC 842, reducing the manual burden on finance teams at month-end close. Your lease accounting team is busy — between tracking operating expenses, triple checking lease commencement dates,  exporting monthly journal entries and lease amortization schedules, all in accordance with new accounting compliance standards. 

With Occupier, your team can save 50% of time on lease accounting tasks and trust you'll pass our annual audit. Schedule a demo to learn about our dedication to your organization's lease accounting responsibilities.