Does your company lease office space, equipment or vehicles? If you issue financial statements based on generally accepted accounting principles (GAAP), the new lease accounting standards significantly impact accounting for those leases.
The new standard, Accounting Standards Codification (ASC) 842, requires virtually all leases to be recognized on the balance sheet, which substantially changes a company’s balance sheet and impacts its financial ratios.
While the new standards might seem relatively straightforward, they can be challenging to implement.
To help you better understand lease accounting under the new standard, we’ve put together this overview of the challenges and perspectives companies should be aware of when it comes to implementation.
Overview of the New Lease Accounting Standard
One of the first challenges of complying with the new standard is identifying whether a contract is or contains a lease.
According to Financial Accounting Standards Board (FASB), a lease is “a contract, or part of a contract, that conveys the right to control the use of identified property, plant or equipment for a period of time in exchange for consideration.” One of the first challenges of complying with the new standard is identifying whether a contract is or contains a lease.
Under prior rules, only capital leases (now referred to as finance leases under ASC 842) were recorded on a company’s balance sheet. Operating leases were considered off-balance-sheet transactions and only mentioned in the financial statement disclosures.
The rationale behind ASC 842 is that recognizing all leases on the company’s balance sheet will better present the lessee’s obligations to users of financial statements.
The only exception is for operating leases with a term of 12 months or less, where any purchase option is reasonably certain not to be exercised. For these short-term leases, the lessee can make an accounting policy election not to recognize the leased asset and lease liabilities.
Per the new lease accounting standard, there are now five criteria for classifying a lease as a finance (or sales-type) lease:
- Transfer of ownership occurs by the end of the lease term
- The agreement contains an option to purchase the asset, and the lessee is reasonably certain to exercise that option.
- The lease term represents a major part of the asset’s remaining economic life.
- The present value of the lease payments equals or exceeds the asset’s fair value.
- The asset is so specialized in nature that it provides no alternative use to the lessor after the lease term.
If the contract meets one or more of the above criteria, it must be classified as a finance lease.
Balance Sheet Changes
For finance and long-term operating leases, the new standard requires the following to be presented separately on the balance sheet (or disclosed in the footnotes):
- Finance lease right-of-use (ROU) assets and operating lease ROU assets
- Finance lease liabilities and operating lease liabilities
Presentation of leases on the income statement and statement of cash flows remains essentially the same.
Ratio Analysis Impacts
Because the new lease accounting standard potentially increases total debt shown on the company’s balance sheet without impacting total equity, companies may see a negative impact on their debt covenants.
Practical Expedient Package
In response to concerns that ASC places an extreme demand on entities to review the details of every contract—even expired ones—FASB created a package of practical expedients.
If elected, the package must be applied consistently to all of the entity’s leases—it cannot pick and choose which leases to apply the expedients to—and all three components must be elected together.
- No need to assess whether expired or existing contracts are or contain leases
- No need to reassess the classification of expired or existing leases. For example, all existing operating leases will continue to be classified as operating leases.
- No need to reassess initial direct costs for any existing leases
For many companies, electing this package is the right move. However, this option does not allow companies to carry forward previous errors. So, if the company knows it has classification errors or omissions in accounting for embedded leases, it cannot elect the package.
Potential Challenging Areas of the New Lease Accounting Standard
Many companies significantly underestimated the hidden challenges associated with implementing ASC 842. Here are a few of those challenges.
Another aspect of the new standard that is particularly challenging is embedded leases. Embedded leases are lease agreements that exist within a contract, such as a service agreement. Because it’s part of another contract, it’s common for these lease arrangements not to have been accounted for as leases under the old rules.
Some industries that may be particularly at risk of missing embedded leases include:
- Transportation industry where items are being shipped (service) but are tied to a leased asset (ship, container, etc.)
- IT services/cloud computing where cloud computing is obtained (service), but the contract includes the lease of a server
- Utility arrangements where a power company provides electricity for a parking lot (service) but light fixtures and poles are leased as a part of the arrangement
ASC 842 requires lessees to apply certain criteria to determine whether a contract containing a lease includes one or more non-lease components that should be accounted for separately. If there are non-lease components, the lessee can either:
- Separate lease from non-lease components by allocating the contract’s consideration based on each component’s relative standalone price; or
- Elect a practical expedient, by class of asset, where non-lease components are not separate from the lease component. This results in combining all lease and non-lease components and accounting for them as a single lease component.
Incremental Borrowing Rate
If a contract is identified as a lease, the company needs to record the lease liability and related ROU asset on the books. When calculating the liability, you need to apply a discount rate to calculate future lease payments’ present value. Coming up with that discount rate can be challenging.
Generally, the rate is not implicit in the lease, so the lessee needs to use the incremental borrowing rate (IBR).
ASC 842 defines the IBR as:
“The rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.”
Some options for determining the IBR include analyzing rate for loans funded close to the lease commencement date, obtaining the cost of borrowing from a lender or developing a rate based on the company’s creditworthiness.
The company may apply a single discount rate to a portfolio of new leases (the portfolio approach) if using a single rate doesn’t create a material difference compared to applying individual discount rates to each lease.
FASB also offers private companies a practical expedient whereby they can opt to use the risk-free rate. However, the risk-free rate will generally be lower, resulting in a higher liability.
The FASB provided a gift to private companies with the issuance of ASU 2021-09, Leases: Discount Rate for Lessees That are Not Public Business Entities, by allowing lessees the ability to utilize the risk-free discount rate by class of underlying asset rather than an all-or-none approach.
The new standard provides specific guidance on how to account for subsequent measurement of lease payments. The first step is to determine if the lease modification should be treated as a modification (and remeasured) or accounted for 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 original lease, and the lease payments increase along with the additional ROU.
Even if the modification is not a separate contract, several situations can call for a remeasurement under ASC 842:
- Resolution of contingencies that result in variable payments becoming fixed for the remainder of the lease term
- A change in the lease term
- A change in the assessment of whether the lessee is reasonably certain to exercise (or not exercise) a purchase option
- Changes to amounts likely to be owed under a residual value guarantee
Are Lease Modifications on the Rise?
Due to the business disruptions of COVID-19, we expect to see potential lease modifications and possible terminations for lessors and lessees as businesses continue to analyze their square footage needs going forward.
As businesses work to adopt the lease standard, the possibility of continuing changes to the right-of-use assets and lease liabilities may decline (or increase in certain situations) should modifications be executed to those newly implemented contracts.
Implementing the New Lease Accounting Standard
Implementing ASC 842 is not a simple process, and organizations should not underestimate the time, effort and cost to implement the new standard. Feedback from public companies and early adopters shows there is more to do than expected.
Here are our recommendations for successful implementation:
- Start early. Gather all contracts and lease agreements now and create a process for managing them. Many companies are finding the process is much easier when they use lease accounting software rather than spreadsheets.
- Create your team. Successful adoption requires a team of key members who can educate others and begin the implementation process. This includes IT, procurement, accounting, executives, internal audit, external auditors, etc.
- Determine and document policies. Your policies must cover lease elections, capitalization policies and whether you will separate or not separate lease components.
- Evaluate internal controls. Determine whether internal controls over financial reporting are adequate.
- Discuss with your bank. If implementing the new lease accounting standards will negatively impact debt covenants, discuss options with your bank.
If you have any questions or would like more information on the new lease accounting standards, contact your Warren Averett advisor or ask a member of our team to reach out to you.
This article was originally published on October 30, 2020 and was most recently updated on June 10, 2022.