After previous delays by the Financial Accounting Standards Board (FASB), Accounting Standards Update 2016-02, Leases (Topic 842) must be adopted by private entities with fiscal year ends beginning after Dec. 15, 2021.
The most significant change to note is that lessees will be required to recognize all lease assets and liabilities on their statement of financial position. Private companies with many leases or contracts with potential embedded leases should anticipate dedicating significant resources to adopting ASC 842. Implementing enterprise lease accounting software may also reduce the burden associated with ongoing lease administration and financial reporting matters.
Below is an outline of the standard’s major provisions and the implications for private entity adoption.
The Adoption Process
The ASC Topic 842 adoption process 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 the 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, including cash and non-cash 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 non-lease 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 is provided the 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 is 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 criteria 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 expenses on the statement of comprehensive income. The lease liabilities are reduced using the effective interest method. 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 (considering the lease payments made).
Finally, according to the new lease accounting standards, there are additional disclosure requirements. 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 critical to properly identify all leases and allocate between lease and non-lease 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 and whether any reassessment events have occurred.
Private companies will need to dedicate ample time to adopt ASC Topic 842 – adoption is required for fiscal years beginning after Dec. 15, 2021.
For more information about adopting the lease accounting standard, please contact a member of our team.
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