After some delays, standard changes to the lease accounting model for private companies and not-for-profit organizations are once again on the horizon. The Financial Accounting Standards Board (FASB) agreed to delay the changes issued in Accounting Standards Update 2016-02, Leases (Topic 842) as a result of both the COVID crisis and the significant burden of implementing the proposed changes for businesses. But while the delays may have caused many businesses to de-prioritize a review of existing leases, enacting the new standards in 2022 could mean significant changes for reporting and covenant calculations for nonpublic business entities.
The biggest item to note is that lessees will be required to recognize all lease assets and liabilities on their statement of financial position. Lessees may need to consider these significant changes in anticipation of the rollout in 2022. Below is recap of the standard’s major provisions and the implications for private entity adoption.
The Adoption Process
The process for ASC Topic 842 adoption means first reviewing each lease contract to determine whether the contract contains a lease. Then, it’s important to understand the components of the contract, the lease classification, the accounting treatment, and whether there are reassessments or modifications needed.
Does the Lease Contain a Contract?
There are three requirements for a contract to fall within scope of ASC Topic 842. The first requires a contract to have an identified asset of property, plant, or equipment. The asset can be explicitly or implicitly stated in the contract, and there cannot be a substantive right of substitution. The second requirement is that the contract conveys the right to control the use of the identified asset for a specific period, which means that the customer has the right to obtain substantially all of its economic benefits from the use of the identified asset and the right to direct the use of the identified asset. The third requirement is that the contract contains an exchange of consideration, which can include both cash and noncash payments.
What Are the Components of the Contract?
Once you have identified whether the lease has a contract, the next step is to identify the components of the contract, which include goods and services. Then, you allocate the consideration of the contract to those components based on their relative standalone prices. These components are recorded separately unless you elect the practical expedient to combine nonlease components (like maintenance services) with their related lease components (like the related piece of equipment).
What Is the Lease’s Classification?
Every lease except for short-term leases (which have a lease term of 12 months or less and do not contain an option to purchase the underlying asset that is reasonably certain to be exercised) must be recorded on the statement of financial position. How the lease is accounted for in the statement of financial position depends on the classification of the lease. There are five classification criteria for evaluating a lease for lessees, as follows:
- Ownership of the leased asset transfers to the lessee by the end of the lease term;
- The lessee has an option to purchase the leased asset and is reasonably certain to do so;
- The lease term is for the major part of the remaining economic life of the leased asset (a lease that commences at or near the end of the asset’s economic life are exempt from this provision);
- The present value of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the leased asset; and
- The leased asset is of such a specialized nature that it is not expected to have another use to the lessor at the end of the lease.
Unless the lease qualifies and is recorded as a short-term lease, if one or more of the above criterion is met, the lease should be accounted for as a finance lease. Otherwise, it should be classified as an operating lease.
What is the Accounting Treatment for My Lease?
Leases classified as short-term are recorded on a straight-line basis, with straight-line lease expense recorded in the statement of comprehensive income and a straight-line lease liability recorded on the statement of financial position.
Accounting for finance leases requires right-of-use assets and lease liabilities to be recorded on the statement of financial position. Interest and amortization expenses are recorded on the statement of comprehensive income. The lease liabilities are reduced using the effective interest method (like debt) and the right-of use assets are reduced on a straight-line basis.
With operating leases, right-of-use assets and lease liabilities are recorded on the statement of financial position. However, lease expenses are recorded as straight-line lease expense on the statement of comprehensive income. The lease liabilities are reduced using the effective interest method and the right-of use assets are reduced by the difference between the straight-line lease expense and the amount recorded as a reduction of the lease liabilities (taking into consideration the lease payments made).
Finally, there are additional disclosure requirements according to the new lease accounting standards. Lessees should disclose line items for the operating and finance lease right-of-use assets and lease liabilities as well as current versus long-term leases. The new disclosure requirements include general information, total lease cost segregated by type, weighted averages for remaining lease terms and discount rates, cash flow information, and maturity analysis.
There are several potential challenges for private entities to be aware of when adopting ASC Topic 842. As discussed above, it’s of critical importance to properly identify all leases and allocate between lease and nonlease components.
It’s equally important to determine the correct discount rate to be used. Because most lessees may not know the rate implicit in the lease, it may be necessary instead to determine an appropriate incremental borrowing rate — or the rate the lessee would pay to borrow on a collateralized basis of a similar term in a similar economic environment — adjusted for the length of the lease and the country or region of operation. Alternatively, private entities can elect to use the risk-free rate for the discount rate.
In addition, entities need to have processes in place to track when leases are entered into or modified, as well as whether any reassessment events have occurred.
Time will be needed to adopt ASC Topic 842, and the new adoption date is quickly approaching — fiscal years beginning after Dec. 15, 2021 for private entities.
For more information about adopting the lease accounting standard, please contact a member of our team.
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