As the year-end draws near, many restaurant companies that report under US GAAP are finalizing their lease accounting. During this process, we often observe common mistakes when closing the year. Below are the most frequent errors related to ASC 842 lease guidance, along with tips on how to avoid them.
Updating the lease portfolio
To ensure all leases are properly capitalized on the balance sheet, revisit the lease portfolio and search for new leases that commenced before the end of the fiscal year (see below for the lease possession date). To help identify unrecorded leases, review all rent and lease-related payments made during the year to ensure those leases are included in your existing lease portfolio.
Lease modifications
It is common to receive changes to the contract between the lessee and lessor during a lease term. Under ASC 842, possible lease modifications include additional rights, an extended or reduced lease term, rent payments, and partial or complete termination of the lease.
When to enter modifications:
To correctly record under ASC 842, a modification must be recognized when it becomes reasonably likely to occur. This includes exercising lease extension options. A common mistake is waiting for the modifying event to occur before making the change.
How to enter modifications:
Lease accounting software programs have a built-in option to “modify” or “revise” leases, which should be recorded as of the modification date (the date the modification became reasonably likely to occur). This will allow for updates to the term, rent payments, etc. Common mistakes to avoid include changing lease attributes from previous years and terminating the existing lease before adding a new lease.
Matching fixed assets to lease life:
Ensure that the lease term aligns with the life of the underlying fixed asset(s). Avoid differences between the remaining lease term and the useful lives assigned to leasehold improvements of the related lease. Leasehold improvements have a life equal to the lesser of its useful life or remaining lease term.
For more consideration regarding lease modifications and remeasurements, see “Performing Remeasurements Under ASC 842, Leases”
Definition of Lease Possession Date
New leases commence on the lease possession date. The lease possession date is often defined within the lease agreement as the day the tenant gains physical access to the property, usually the day the tenant receives a key to the building. It is important to distinguish the difference between the lease possession date (commencement date) and the effective date of the lease agreement or the beginning of rent payments. The lease possession date is the date you take control of the property, even if no rent is being charged during this “free rent period”.
Infrequent Reconciliation of Leases
Regular reconciliation of lease assets and related liabilities is crucial. Ideally, leases are reconciled quarterly to identify issues before year-end reporting. Reconciling the beginning-of-year balance for lease assets and liabilities will identify most mistakes. We often see the leases with modifications being adjusted without going through the revision process that your software will do for you. All modification changes are going forward and should not impact prior accounting recognition.
Use of Risk-Free Rate
If a rate implicit in a lease is not readily available, ASC 842 allows organizations to use their incremental or risk-free borrowing rates (US Treasury Rates). When selecting a discount rate, it is essential to have a consistent approach when rounding to the nearest lease term. Most companies have elected to use the practical expedient which allows the risk-free borrowing rate based on the lease term at commencement. For example, if your lease term is 10 years, you would use the 10-year Treasury rate in effect at the commencement date. The link above can provide you with the date-specific rate you need.
Application of Tenant Improvement Allowances (TIAs)
TIAs can be paid before or during the lease term. TIAs are recorded as a reduction of the ROU asset, which reduces the amortization expense of the ROU asset. This effectively reduces the rent expense recognized over the term of the loan. TIAs are accounted for in lease accounting depending on the timing of the payment.
If you receive a TIA on a lease with no base rent and only percentage rent, the TIA is accounted for as a liability as there is no ROU asset to be reduced. The TIA is accreted against rent expense over the term of the lease.
Impairment of ROU Assets
Finally, if a triggering event has occurred, remember to assess your ROU lease assets for impairment alongside your fixed assets. This step is often overlooked, but it can lead to significant adjustments, especially if you have an underperforming store that is unlikely to recover its investment.
To learn more about evaluating for impairment, see Evaluating Your ROU Asset For Impairment.
We recommend starting your year-end lease accounting early to allow time for any questions or clarifications. If you have any questions about lease accounting or would like to discuss details further, please reach out to your GBQ advisor.
Additional guidance can be found here:
- ASC 842 Lease Accounting: Frequently Asked Questions
- ASC 842 Lease Implementation: Don’t Get Left Behind
Article written by: Zach Bonifas & Dustin Minton
