NEW LEASE ACCOUNTING STANDARD: It is Here! – Greg Cargin, CPA, Partner
Since the Financial Accounting Standards Board (FASB) began the process of enhancing the lease accounting standard in 2006, and after several delays of the implementation dates, it seemed that maybe this would never become a reality, but the time has come. Accounting Standards Codification 842 – Leases became effective for companies with fiscal years beginning after December 15, 2021; so many of you are already needing to have this adopted.
What should my organization know?
Under the new standard, almost all leases will be recorded as liabilities on your balance sheet along with a right of use (ROU) asset. Under old guidance only capital leases were recorded as liabilities with offsetting assets that were depreciated. With the adoption of the new standard, what was generally classified as a capital lease, will be called a financing lease; in addition, operating leases will be required to be reported on the balance sheet as well. However, short-term leases, with original terms of 12 months or less, will not fall under the new standard as long as they don’t include a purchase option that is reasonably certain to be exercised.
What does the accounting look like?
The initial lease liability and right of use assets will be recorded on the balance sheet at the present value of the expected future lease payments, determined by selection of an appropriate discount rate.
The lease liability will either be classified as a financing lease or an operating lease depending on the terms of the lease, the lease structure and future uses of the leased asset. This determination will need to
be made at lease adoption. As payments on the lease are made, the liability will be decreased based on scheduled payments as you would generally see from an amortization schedule. The income statement will be impacted by the straight-line amortization of the ROU asset, either through amortization expense (in the case of a financing lease) or lease expense in the (case of an operating lease). There will also be an interest component for the financing leases.
When negotiating and reviewing lease terms, a company will want to keep in mind that the longer the lease term, the greater the liability on the company’s balance sheet. Depending on the structure of leases, guaranteed residuals, renewal option periods, and other lease terms, the increase in the lease liabilities will alter your debt-to-equity, working capital and leverage ratios. You will want to make sure to communicate with your lender of potential pitfalls with covenants, if identified.
What should we be doing now?
First and foremost, your company needs to be putting together a complete listing of all leases that are currently active. The following questions should be considered:
+ Does your company have a complete listing of all leases, including vehicles, copiers and other office equipment, facilities and other storage leases, railroads, etc., including various starting and ending dates?
+ Does your company have any lease arrangements embedded in other contracts and/or assessed any service contracts for embedded leasing arrangements?
+ Has your company assessed its capitalization threshold to scope out low-value leases? (This may also be a good time to update or adopt a good capitalization policy for your organization)
+ Does your company have any sublease arrangements?
Once all leasing arrangements have been identified, preparing for the updated accounting under the new standard will need to be addressed. One of the key challenges of adopting the new standard is that the data requirements are extensive. For purposes of the transition, some of the key data points that will need to be identified include the following:
+ Lease terms and dates (commencement, renewals, extensions, purchase options, early termination, etc.)
+ Payment details (timing of payments, amounts, purchase options)
+ Other existing accounting (prepaid or deferred rent or lease balances)
+ Discount rates (the new standard requires the lessee to measure the lease liability and corresponding ROU asset using the rate implicit in the leasing terms, or if not known, an incremental borrowing rate.)
Additional guidance is available related to discount rates, incremental borrowing rates and the application of those rates, and the judgments and estimates needed for the measurements - that discussion is overly complex for this communication. Please reach out to your Gardiner + Company auditors for additional information on this topic.
Prior to adoption of ASC 842, many companies didn’t spend many resources or used fairly simple tools as capital leases were fairly easy to identify and accounting for operating leases was very straightforward. This is not the case today as virtually all leases will be on the balance sheet. Depending on the number of leases you identify, you may find that Excel will provide the tools necessary to track and compute the information necessary. We believe this won’t be the case for most. Similarly, to what Gardiner + Company does today for property, plant, and equipment (having software we use to help manage your depreciation schedules), we have been extensively looking at lease software to assist our firm, and ultimately your company, by providing the tools necessary to assist in managing the lease accounting as it will be more difficult than it has ever been in the past. We have elected to use a product called NetLease. Of course, you are more than welcomed to research your own software to provide the information necessary for the new accounting, but we also have some options available for you to purchase NetLease through us at a discount, or have us implement NetLease for you as a service. Please reach out for more information on this product we will be working with.
We can certainly assist your company with the transition to the new accounting required under ASC 842, but accounting for these transactions correctly starts internally. For some with very few leasing arrangements, this new standard may not be a big lift, but I believe many will find they have a surprising number of leasing arrangements once they have gone through the identification process, making this a more difficult and complex process. For many companies today, you are in the implementation period, for the rest, you need to be considering the impact on the monthly reporting process and the resources necessary to properly account for the new standard. Like it or not, the time is here!