By Lisa Blankman, CPA
Manager, Audit & Assurance Services
Back in 2016, the Financial Accounting Standards Board (FASB) published ASC 842, a new lease accounting standard that ensures transparency and auditability in financial reporting.
The new standard requires companies to record virtually all leases on their balance sheet, no longer allowing them to hide certain assets and liabilities in the off-balance-sheet leasing that was so prevalent under the previous leasing standard, ASC 840. Now, the balance sheet will better present the lessee’s obligations to users of financial statements. From the lessor perspective, however, there is not a significant impact under the new ASC 842 standard.
Under ASC 840, only capital leases had to be reported on the balance sheet. Now, operating leases have to be accounted for as well. Under ASC 842, the two types of leases for lessees are now classified as finance (formerly known as capital), and operating leases. One of the following criteria must be met to qualify as a finance lease:
- Ownership transfers to the lessee at the end of the lease term.
- The agreement includes an option to purchase the asset at a bargain, and the lessee is reasonably certain they will exercise that option.
- The lease term represents a major part of the asset’s remaining economic life.
- The present value of the lease payments represents substantially all of the fair value of the asset.
- The asset is of no valuable alternative use to the lessor after the lease term.
If none of the above apply, then the lease is classified as an operating lease. For both finance and operating leases, companies must then calculate and report leases as right-of-use (ROU) assets and lease liabilities on the balance sheet.
How to calculate lease liabilities:
- Present value of all scheduled payments, including fixed and variable payments based on index or rate, any guaranteed residual value, purchase price option expected to exercise, termination penalties if expected to exercise, fees paid to owner for special structuring of lease.
- Discount rate to calculate the present value must be determined for each asset class using one of the following options:
- Rate implicit in lease (must be used if able to be determined).
- Incremental borrowing rate — rate lessee could obtain for loan to purchase asset.
- Risk-free rate — typically US Treasury rate
How to calculate ROU assets:
- Initial lease liability + Prepaid lease payments + Initial direct costs – Any lease incentives received – Deferred rent
Other Lease Considerations
ASC 842 requires evaluation of various aspects of the lease when determining how all costs are treated and what is disclosed. For example, each lease should have determined all lease (fixed and variable rent payments) and non-lease components (CAM charges, maintenance, landscaping, etc.). These may be combined and included in calculation of lease liability and ROU asset, or treated separately and expense non-lease components as they occur. If your financial statements include footnote disclosures, those will be expanded to disclose the terms of the lease and incorporates both qualitative and quantitative information, including the disclosure of weighted average of remaining lease term and weighted average discount rate for both finance and operating leases.
Lease modifications are another area to consider for evaluating and reassessing lease treatment. The first step you should take is determining whether the modification should be remeasured or treated as a separate contract.
You should treat the modification as a separate contract if it grants the lessee an additional ROU not included in the initial lease agreement. Even if the modification is not a separate contract, several scenarios can call for a remeasurement under ASC 842, such as:
- The resolution of contingencies that result in variable payments becoming fixed for the rest of the lease term.
- A change in the term of the lease contract.
- A change in the assessment of whether the lessee is reasonably certain to exercise a purchase option.
- Changes to amounts expected to be owed under a residual value guarantee.
Transitioning Toward ASC 842 Standards
The updated standard is in effect and required to be implemented for GAAP financial statements for periods beginning after December 15, 2021. See below for guidelines on the implementation process.
- Consult with your accountant and users of the financial statements. Verify your requirements to follow GAAP and the new lease standard.
- Start smart. Take advantage of ASC 842 software or Excel templates to assist in calculations of ROU assets, liabilities, and expenses. We can assist in the calculations as well!
- Build an ASC 842 team. Smooth transition to this new standard requires a dedicated team of key members who can teach and supervise others through the implementation process.
- Determine your policies. Your policies should cover lease elections, capitalization protocols, and lease components treatment.
- Consult your lending sources. Will implementing the new lease accounting standards negatively impact debt covenants? Sit down with your lender to discuss different options and potential outcomes.