How to Adopt the New Lease Standard for Private Companies
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. ASC 842 requires that for all leases with terms of more than 12 months at the commencement date, lessees must recognize: 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.
Calendar year-end privately held companies were required to adopt ASC 842 effective January 1, 2022. Privately held companies with fiscal year-ends were required to adopt ASC 842 in the fiscal year beginning after December 15, 2021. Public companies already adopted ASC 842. Consider these steps as you evaluate the impact of ASC 842 on your company:
1. Identify your leases.
ASC 842 defines a lease as “a contract, or part of a contract, which conveys the right to control the use of identified property, plant or equipment (an identified asset) for a period of time in exchange for consideration.” Some common leases include those for offices or buildings, copiers, postage machines, vehicles, or equipment.
2. Inspect your contracts for embedded leases.
Embedded leases are contained within larger agreements and are commonly found in IT contracts, cable services, transportation and delivery services, joint-operating agreements, and contract manufacturing agreements. Failing to appropriately identify a lease under ASC 842 can negatively impact your financial statements, so inspect your contracts for embedded leases carefully.
3. Evaluate your leases to determine if they’re operating or finance leases.
The new lease accounting standard requires lessees to classify all leases as financing or operating. Under ASC 842, a lease is considered a finance lease if it meets 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.
Operating leases are any leases that do not meet the criteria for a finance lease. While both finance and operating leases are recorded on the balance sheet under ASC 842, the expense recognition pattern differs. For operating leases, lessees recognize the lease expenses on a straight-line basis over the lease term. For finance leases, lessees recognize interest expense and amortization expense.
4. Select a transition method.
Companies must transition to ASC 842 using a modified retrospective method and may choose from two options for the initial date of application:
- 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.
ASC 842 contains practical expedients companies may elect when classifying their leases:
- 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.
- Hindsight, which allows lessees to make assumptions about the lease term and value of the right-of-use asset at commencement using current information.
- Elect not to reassess existing or expired land easements under the definition of a lease under ASC 842.
- 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).
- Combine lease and non-lease components.
These practical expedients are intended to ease the stress of adopting the new standards on companies.
6. Determine the discount rate that should be used for present value calculations.
The discount rate is used to calculate the lease liability at the lease inception date. Private companies can consider the applicable federal rate or use the company’s incremental borrowing rate as defined.
7. Evaluate how many leases 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: It keeps lease information in a single location that can be easily accessed and is able to run reports for both interim periods and year-end. Lease software also calculates the information for required footnote disclosures, and 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, a spreadsheet might be appropriate to perform the lease calculations. Be aware that spreadsheets are generally at a point in time, so if an interim report is needed, the spreadsheets 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. Upon adoption of ASC 842, a company will record a non-current right of use asset and a corresponding liability that consists of a current portion and a non-current portion. This change to the balance sheet will have a significant impact on covenant calculations and may result in the company violating loan covenants.
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, an explanation of variable lease payments, terms and conditions of options to extend or terminate the lease, residual value guarantees, subleases, significant assumptions and judgments made, treatment of lease costs, future maturities, policy elections and practical expedients. Consider these requirements when abstracting your leases.
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