By Matthew Nash, CPA
The implementation of the Financial Accounting Standards Board’s (FASB) new lease accounting standard, ASC 842, presents a major challenge for companies that produce financial statements under Generally Accepted Accounting Principles (GAAP).
After almost seven years since the release of Accounting Standards Update (ASU) 2016-02 in February 2016, these organizations must now work toward implementing ASC 842 for the 2022 fiscal year. This article will provide an overview of the key changes that need to be made in order to ensure compliance with the new lease-accounting standard.
What Is ASC 842?
This standard intends to provide visibility on a company’s capital needs and obligations, improve consistency in financial-statement presentation, provide enhanced disclosures to the readers of the financial statements, and improve the comparability of lease practices across entities and industries.
Under the new standard, lessees are required to account operating leases with terms longer than 12 months on the balance sheet, resulting in the recognition of a right-of-use asset and the corresponding liability. Under the previous standard, ASC 840, the only leases that were required to be accounted for on the balance sheet were capital leases, which are now referred to as finance leases under ASC 842. Prior to ASC 842, operating leases required disclosure only in the notes to the financial statements.
Lessor accounting practices remain largely unchanged from ASC 840 to 842.
What Qualifies as a Lease Under ASC 842?
To better understand the new lease standard, you must first understand the definition of a lease. A lease is defined as the contract, or part of a contract, that conveys the right to control the use of an identified property, plant, or equipment for a period of time in exchange for consideration.
To simplify this definition, a lease is a physical asset that a company has the right to direct the use of for economic benefit. The most common examples of leases are office space, machinery, vehicles, equipment, and land.
What Steps Should Companies Take to Prepare?
To prepare for adoption of this standard, companies first need to account for all their existing leases and thoroughly review the contracts to determine whether they include an operating or a finance lease.
Do You Have an Operating Lease or Finance Lease?
If the lease meets any of the following criteria, it will be classified as a finance lease:
• Does the lease transfer ownership at the end of the lease term?
• Does the lease grant the lessee a right-to-purchase option that is lessee is reasonably certain to exercise?
• Is the lease term for the major part of the economic life of the underlying asset?
• Does the present value of the sum of lease payment and any residual value guaranteed by the lessee not reflected in the lease payments equal or exceed substantially all of the underlying asset’s fair value?
• Finally, is the underlying asset of such a specialized nature that it is not expected to have an alternative use to the lessor at the lease term end?
If the answer to all five of those questions is no, then the lease qualifies as an operating lease.
After concluding the lease type, it is time to dig into the lease details:
• When does the lease start?
• When does the lease end?
• Are there early termination or renewal options?
• Are there variable expenses related to the lease?
• What is the monthly cost of the lease?
The answer to all these questions is integral to the calculation of the asset and liability to be included in the financial statements. Once the total future lease obligation has been calculated, the obligation will be presently valued using one of three discount rate options. The newly recognized right-of-use asset and liability will then be amortized over the life of the lease, based on the lease type.
For income-statement purposes, operating leases will continue to be classified as lease expense, and finance leases will be split between amortization expense and interest expense.
As part of the initial adoption of the new lease standard, there are certain practical expedients that can be adopted to help make the transition easier. Companies are not required to assess existing lease classifications. Existing operating leases with terms extending beyond 12 months will be included on the balance sheet effective Jan. 1, 2022, the date of required adoption. Existing capital leases will continue to be included with property, plant, and equipment, and will be amortized over the remaining life of the lease.
Financial-statement Disclosure Impacts
Aside from the impact on the balance sheet, the standard will also provide enhanced disclosures in the notes to the financial statements. The required disclosure will include qualitative and quantitative disclosures, including descriptions of the existing leases, disclosure of lease expenses as included in the income statement, cash paid for leases during the current year, new right-of-use assets obtained through operating and finance leases, weighted average of discount rate used to present value the lease obligation, and the maturity analysis disclosing the future obligations to be paid.
The new lease standard is expected to have the biggest impact on those companies with a large volume of real-estate leases that have previously been required to be disclosed only in the footnotes to the financial statements. The overall expectation is that most companies with leases will see some impact related to the adoption of the new standard. Because the new standard has a balance-sheet impact, it is recommended that all companies review any financial covenants and proactively work with financial institutions to consider whether amendments to covenants may be required.
There are many intricacies within the new lease standard, and it will be a learning process for all of those involved in preparing their company’s financial statements. The best thing a company can do is take the time to make sure that they fully understand how each lease is written, and to have an open dialogue with their CPA.
Matthew Nash, CPA is a senior manager at the Holyoke-based accounting firm Meyers Brothers Kalicka, P.C.; (413) 536-8510.