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.
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:
- Does the ownership transfer to the lessee at the end of the lease term?
- Is the purchase option reasonably certain of being exercised?
- Is the lease term a major part of remaining economic life (the old standard defined this as greater than 75%)?
- 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.
- 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.