How to Adopt the New Lease Standard for Private Companies
September 22, 2022
William Ryan and Christopher Giordano
In February 2016, the Financial Accounting Standards Board (“FASB”) issued its new lease accounting guidance in ASU No. 2016-02, Leases (Topic 842), referred to as ASC 842. The standard requires lessees to recognize for all leases (with terms of more than 12 months at the commencement date) the following: a) a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis, and b) a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term.
Public companies have already adopted ASC 842.
Calendar year-end privately held companies are required to adopt ASC 842 effective January 1, 2022. Privately held companies with fiscal year-ends are required to adopt ASC 842 in the fiscal year beginning after December 15, 2021.
If you have not adopted the lease standard yet, consider these steps as you evaluate the impact of ASC 842 on your company:
1. Identify your leases. Some common leases are for offices or buildings, copiers, postage machines, vehicles, or equipment.
2. Evaluate contracts for embedded leases.
3. Evaluate the leases to determine lease classification as operating or finance leases.
- Finance leases meet one or more of the following criteria:
- Transfer of ownership occurs by the end of the lease term.
- The lease agreement contains a provision where the lessee has the option to purchase the asset, and that option is reasonably certain to be exercised.
- The lease term represents the major part of the asset’s economic life.
- The present value of lease payments over the lease term, calculated at lease commencement, equals or exceeds substantially all of the fair value of the asset.
- The leased asset is of a specialized nature such that it has no alternative use to the lessor.
b. Operating leases are any lease that does not meet the criteria for a finance lease.
4. Select a transition method:
- Comparative method – retroactively adjust prior comparative periods in financial statements (all financials presented would account for leases under ASC 842).
- Effective date method – account for leases under ASC 842 beginning January 1, 2022 without adjusting prior years. Prior year financial statements would account for leases under ASC 840.
5. Consider practical expedients:
- The package of practical expedients, which must be elected together.
- No reassessment of lease classification for existing or expired leases.
- No reevaluation of embedded leases for existing or expired contracts.
- No reassessment of initial direct costs.
b. Hindsight, which allows lessees to make assumptions about the lease term and value of the right of use asset at commencement using current information.
c. Land easements -- elect not to reassess existing or expired land easements under the definition of a lease under ASC 842.
d. Short-term lease exemption which allows lessees to not capitalize leases with a term of twelve months or less at lease commencement date (not adoption date).
e. Combine lease and non-lease components.
6. Determine the discount rate that should be used for present value calculations. Private companies can consider the applicable federal rate, or use the company’s incremental borrowing rate as defined.
7. How many leases do you have?
- If you have more than a handful of leases or complex arrangements, consider using software that performs the calculations for you. Lease software accomplishes several things. Lease information is kept in a single location and can be easily accessed. Reports can be run for both interim periods and year-end. Information for required footnote disclosures are calculated by the lease software. The reports from the lease software aggregate the leases to calculate the ending right of use asset, finance or operating lease liability, lease expense, interest expense, and depreciation expense.
- If you have less than a handful of non-complex leases, an Excel template might be appropriate to perform the lease calculations. The Excel templates are generally at a point in time so if an interim report is needed, the Excel templates will need to be updated.
8. Complete the lease calculations and record the necessary adjustments to the general ledger.
9. Calculate your financial covenants as required by any loan or other agreements. Discuss the impact of ASC 842 with your banker before year-end, especially if you will need a covenant waiver.
10. Draft the required footnotes for your financial statements. ASC 842 has significantly more disclosure requirements than previous guidance. The footnotes must include a description of the leases, explanation of variable lease payments, terms and conditions of options to extend or terminate the lease, residual value guarantees, subleases, significant assumptions and judgements made, treatment of lease costs, future maturities, policy elections and practical expedients. Consider these requirements when abstracting your leases.