accounting made sense

Month-To-Month Lease Under ASC 842 – a Simple Guide

Month-To-Month Lease Under ASC 842 – a Simple Guide Featured Image

Table of Contents

ASC 842 introduces comprehensive lease accounting requirements for both lessees and lessors to navigate. With its detailed guidelines and reporting standards, it’s understandable that many are left questioning whether their simple, month-to-month leases need to go through the hassle.

We will provide a clear explanation to illustrate how these month-to-month leases can be exempted from the regular ASC 842 treatment, along with a journal entry example.

Related reading: Interested in learning more about the “regular ASC 842 treatment”? Check out these guides:

ASC 842 Journal Entries – Operating Lease (Lessee and Lessor)

ASC 842 Journal Entries – Finance Lease (Lessee)

ASC 842 Journal Entries – Sales-type Lease (Lessor)

ASC 842 Journal Entries – Direct Financing Lease (Lessor)

ASC 842 Lease Extension & Renewal

Requirement and Guidance for Short-term Exemption

FASB Guidance

Per ASC 842-20-55-14 to 16, leases that meet the definition of a short-term lease can elect not to recognize right-of-use assets and lease liabilities.

What this means: A lease that meets the definition of a short-term lease does not need to go through the typical ASC 842 requirement.

Sounds promising, right? Before we jump to the conclusion, let’s look at the definition of a short-term lease.

Definition of Short-term Lease

A short-term lease must meet the following criteria at commencement:

  • Criterion 1: It has a lease term of 12 months or less.
  • Criterion 2: It does not contain an option to purchase the underlying asset the lessee is reasonably certain to exercise.

Let’s start with the easier one first: if you aren’t given the option to purchase the asset at the end or don’t want to, even if you have the option, then you meet criterion 2. 

Criterion 1 is where it gets slightly tricky. What is the lease term in a month-to-month lease? Is it more or less than 12 months? Let’s take a look at the definition of lease term.

Definition of Lease Term

Per ASC 842-10-30-1, A lease term is the noncancellable period of the lease, together with all of the following:

  1. Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option
  2. Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
  3. Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor.

Here is a simplified interpretation:

Noncancellable period

What this means: it’s the length of the lease period that cannot be canceled. For example, if you can simply call the lessor and cancel the lease next month, your noncancellable period is just one month or less. But if the lease term states you can’t cancel the lease within 12 months, your noncancellable period is 12 months.

 1. Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option

What this means: If you (as the lessee) have the option to extend the lease and you likely will extend it, those periods that you want to extend will have to be added to your calculation of the lease term.

For instance, if the lease term says the month-to-month lease is auto-renewed indefinitely as long as you pay (also called an “evergreen lease”), it boils down to how long you actually want to keep this auto-renewal option. 

Will you likely keep the auto-renewal on for at least a year? Then, add a year to your noncancellable period to determine the lease term. 

What if you do not know how long you will renew (like renting a temporary place until you find a permanent space)? Then, this period is nearly zero for now because you are not reasonably certain how long you will keep renewing the lease. It could be as soon as this month’s end or next; you just don’t know. However, you must perform this assessment frequently until there is more clarity on how long the lease will last.

2. Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option

What this means: You (as the lessee) can cancel the lease anytime you want, but you will need to ask yourself how long you’d like to keep renewing the lease, and those periods need to be added to your calculation of the lease term.

For example, if you plan to keep the lease for at least a year, you should add that year to your noncancellable period. If the answer is maybe just another two months, then you add two months to your noncancellable period to determine the lease term.

3. Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor.

What this means: You (as the lessee) can extend the lease for a certain period, but it’s the lessor who decides whether they’d like to extend. In that case, those periods need to be added to your noncancellable period to determine the lease term. 

For example, if the lease term says the lease can be extended by another year, but the lessor has the ultimate say in whether they want to extend, you will need to add the one year to your noncancellable period.

In conclusion, a lease must first be classified as short-term to be exempt from ASC 842 treatment. A short-term lease has a lease term of 12 months or less and doesn’t have the option for the lessee to purchase the asset (or the lessee won’t likely purchase even if they are given the option.)

I know it’s a lot to digest – so let’s take a look at a few month-to-month lease scenarios:

Real-world Scenarios of Month-to-month Lease

Scenario 1: As the lessee, you can cancel the month-to-month lease anytime. You can renew indefinitely but do not intend to keep the lease for over 12 months. You also don’t have the option to purchase the asset or don’t want to, even if you have the option.

Lease term: Less than 12 months. The noncancellable period is nearly zero. And you don’t expect to keep renewing the lease for more than 12 months.

Conclusion: It is a short-term lease eligible to be excluded from ASC 842 treatment.

Scenario 2: As the lessee, you can cancel the month-to-month lease anytime. You can renew indefinitely and want to keep the lease for more than 12 months. 

Lease term: More than 12 months. The noncancellable period is nearly zero. But you would like to keep renewing the lease for more than 12 months. This automatically disqualifies the lease to be classified as a short-term lease.

Conclusion: It is not a short-term lease. It can not be exempted from ASC 842 treatment.

Scenario 3: As the lessee, you can cancel the month-to-month lease anytime. You can renew indefinitely, but you have no idea how long you will keep renewing the lease. You also don’t have the option to purchase the asset or don’t want to, even if you have the option.

Lease term: Less than 12 months. The noncancellable period is nearly zero. And you don’t know how long you will keep renewing the lease. So, essentially, the lease term is virtually zero in this case. However, you’ll need to regularly reassess the situation until you have a clearer idea of the lease’s duration.

Conclusion: It is a short-term lease eligible to be excluded from ASC 842 treatment for now, but a re-assessment must be performed regularly to further support this eligibility.

Scenario 4: As the lessee, you entered into a lease, but the noncancellable period is 12 months per the lease agreement. You have the option to renew month-to-month after. You also don’t have the option to purchase the asset or don’t want to, even if you have the option.

Lease term: Depends. Because the noncancellable period is 12 months, the lease term is, at the minimum, 12 months. If you intend to extend the lease for even just another day, it will become a long-term lease. But if you don’t think you will extend the lease, or in professional terms, “not reasonably certain” you will do so, then it can be argued the lease term is still 12 months, thus meeting the cut-off for a “short-term lease.”

Conclusion: It depends on whether you, the lessee, intend to renew the lease after the 12-month noncancellable period. If you don’t, then it’s a short-term lease that can be exempted from ASC 842. If you do, it’s a long-term lease subject to the ASC 842 treatment.

This guide covers the four most usual cases for month-to-month leases under ASC 842. We aim to make things easier to understand. But please keep in mind that there are trickier cases, such as nonconsecutive leases or ambiguously defined “noncancellable periods.” It’s best to talk to an expert or look up more detailed technical guidance for those.

Related reading:

What Is a Lease Accountant and What Do They Do?

Journal Entry Example 

Let’s say your month-to-month lease can be classified as a short-term lease, and you are ready to choose not to go through the ASC 842 treatment. Congratulations! Below is the only journal entry required for this type of lease:

Month to Month Lease ASC 842 Journal Entry Example

A simple debit to rent expense and credit to cash or AP will do the job. No ROU assets or liability need to be recognized.

Conclusion

In short, figuring out lease accounting with ASC 842 can be complex, even for month-to-month leases, but it’s crucial to understand it properly. This guide has broken down the rules for short-term leases and explained when month-to-month leases can skip the full ASC 842 requirements.

Keep in mind that while some month-to-month leases are clearly short-term, others may require more detailed examination. It’s best to consult an expert or research the technical guides when the situation is complicated.

Leave a Reply

Your email address will not be published. Required fields are marked *

Table of Contents