ASC 842: Implementing the New Lease Standards

January 08, 2022

New standards for leases longer than 12 months make it even more important that businesses talk to their accountant about their financial and operating leases.


Transcript

Erika Ballo: Under the previous lease standards, Accounting Standards Codification (ASC) 840, future payment obligations for operating leases were not reflected on the balance sheet even if a company was committed to many years of payments. These leases were only disclosed in the notes to the financial statements.

ASC 842 is a major change in lease accounting, which requires all leases longer than 12 months to be recorded on the balance sheet.

For private companies, this is effective for reporting periods beginning after December 15, 2021. Once adopted, all leases longer than 12 months will be recorded on the balance sheet as a Right of Use Asset and a corresponding Lease Liability. The goal is to bring off-balance sheet commitments on to the balance sheet, so that the financial statements show all of the assets and all of the commitments of the company.

There are two types of leases under ASU 842, finance leases and operating leases. The criteria to classify a lease as finance or operating lease is similar to current lease standards, only less rigid, therefore requiring more judgement. The five criteria are as follows:

  1. Does the ownership transfer to the lessee at the end of the lease term?
  2. Is the purchase option reasonably certain of being exercised?
  3. Is the lease term a major part of remaining economic life (the old standard defined this as greater than 75%)?
  4. Does the Present Value of the lease payments + guaranteed residual value equal or exceed substantially all of fair market value of the underlying asset (the old standard defined this as 90% or more). In the new standard, the exact amount is not specified, so here the entity has to use some judgement.
  5. Is the asset a specialized asset with no alternative use to the lessor?

If all answers are yes, we have a finance lease, if any of the answers are no, we have an operating lease.

Both Finance and Operating leases will be recorded on the balance sheet as a Right of Use of Asset and a Lease Liability.  The Right of Use of Asset and the Lease Liability are calculated at the present value of all the future lease payments (plus initial direct costs, prepaid lease payments, less any incentives received).

The significant difference between finance leases and operating leases is how the lease payments flow through the Income statement.

For a Finance lease, the total lease expense will be the sum of interest expense on the lease liability and amortization expense of the asset. Total lease expense changes every year. Interest expense will be higher in the beginning, as the liability will be higher.

For an operating lease, there is no interest, amortization or lease expense on the income statement, there is only rent expense. Rent expense will be constant every year over the period of the lease, as it will be recorded on a straight line basis.

Implementing the new lease standard does not change the way a business operates; however, it may have significant implications on the financial statements.

Debt covenants may be impacted because a new asset and new liability are added to the balance sheet.

In addition, financial ratios may change significantly. Management and investors use these ratios to make decision on operating and investing needs of the business.

Last, but not least, footnote disclosures on the financial statements will be longer and more detailed.

Addressing these matters in a timely manner is key.  Companies should start assessing their leases now to help avoid unpleasant surprises such as violation of debt covenants.  The best thing to do is to start working early with your accountant to assess the impact the adoption of the new lease standard will have on your financial statements and reach out to your lender to renegotiate debt covenants, if necessary.

So here is the to do list: review all lease contracts, document the analysis of the lease contracts, calculate and record a right to use asset and  lease liability, and estimate the impact of the lease accounting changes on your covenants and ratios, talk with your banker and accountant.  

Please contact us if you have any questions, we are happy to help.  

About Erika Ballo

Erika Ballo is in the Private Business Services Group with over five years in both public and private experience.


More in This Series

Understanding the Financial Closing Process

Standard policies and procedures for closing the books is essential in creating comparable month over month reporting. Learn what to consider when constructing a formalized quarterly and annual financial closing process.

How to Find Investors for Your Business

Looking for quality investors for your new company is a challenging task. Learn how to utilize your existing network to be at the top of an investor’s mind.

Options to Help Finance a New Business

Learn more about where to get financing during the early stages of a new business.

Starting Your Business as a Sole Proprietorship

Discover the considerations and challenges when starting your business as a sole proprietorship.

S Corporation vs. C Corporation: Breaking Down Different Tax Requirements for New Corporations

Choosing the entity type of your new business can be complex and overwhelming. Learn the differences in tax requirements and qualifications and see which is the best fit for you.

Operating and Managing Your Business to Minimize Your Tax Bill

Accurate and thorough recordkeeping can save your business a lot of time and money. Discover the key areas a knowledgeable tax professional can advise you on in this new tax environment.

Tax Exit Strategies When Selling Your Business

Keeping good books and financial statements can help you to secure a deal when selling your business. A qualified tax professional and advisor can help you perform the due diligence required prior to a successful sale.

Internal Controls for Inventory, Equipment and Assets

There are many important procedures to consider when setting up internal controls for your new business. Learn more about how detailed recording and periodic checks and balances can help you avoid discrepancies.

Libor Rate Changes and the Future of Your Business

An explanation of plans to phase out of the LIBOR rate, and the important discussions and actions you need to take now to prepare your business.

Going Concern and How It will Impact Your Financial Statement

A spotlight on going concern, and the steps to follow when evaluating your small business and its operating and commitment obligations.

Driving Success with Financial Management

Implementing an accounting system for your business will enable more success and profit maximization. Follow these steps to create a solid foundation for the financial management of your business.

Tax Considerations When Starting Your New Business

Starting a new business can be difficult and overwhelming, and filing your first tax return can seem daunting. Find out how you can make this process go more smoothly.

How to Have Good Internal Controls for Cash Disbursements

How can we have good controls over cash disbursements in a small to mid-sized Company? The first step is your vendor setup. You can go through similar steps for other risks you identify such as receiving invoices, payment approval, and payments.

What are the 5 Components of Internal Controls

Creating internal controls not only prevents fraud and loss of assets, but it also improves the accuracy of financial records and helps the business run smoothly.

Revenue Recognition Standard ASC 606

ASC 606 applies to most contracts with customers with some exceptions.  This revenue recognition model is based on a control approach rather than a risk and rewards approach used in the prior model.

Finance a New Business

Learn where to acquire financing during the early stages of a new business.