Lease Accounting Standards
Lease accounting standards are changing, aiming to improve transparency and make it easier to compare statements. Here’s what you need to know.
What is ASC 842?
ASC 842 stands for Accounting Standards Codification 842, also known as the updated lease accounting standards being implemented by the Financial Accounting Standards Board. ASC 842 affects the way leases are reported under GAAP and introduces the right-of-use model that shifts from the risk and rewards approach to a control-based approach.
Why is the FASB updating lease accounting standards?
Overall, the FASB is updating lease accounting standards to improve clarity in accounting. The new standards will move off balance sheet leasing arrangements, like operating leases, on to the balance sheet which will allow investors and other uses of financial statements to more readily and accurately understand the rights and obligations associated with the leases a company is beholden to. Additionally, the new lease standard will increase transparency and comparability among organizations that lease buildings, equipment, and other assets by recognizing the assets and liabilities that arise from lease transactions.
What are the new lease accounting standards?
This change in compliance isn’t quite as simple as transferring where you’re reporting your leased assets.
Previously, there were two ways to classify a lease:
- As a “capital” lease, where ownership of the asset transferred to the lessee. Capital leases were recorded on the balance sheet.
- As an “operating” lease, where only the right to use the asset transferred. Operating leases were not included on the balance sheet, but were disclosed in the footnotes of the financial statements.
With the new lease accounting standards, you’ll want to take each lease individually and assess how you will account for the leased asset:
- Month-to-month leases: Review any current leases you have listed as month-to-month. If the asset is solely used by the lessee and the lessee is guaranteeing the debt by providing the cash flow necessary to service the debt, then a longer lease may be appropriate.
- Related-party leases: Although these leases may be a month-to-month or under 12 month arrangement, depending on the situation, if the arrangement functions more like a longer-term lease, it must be recorded on the balance sheet.
- Job costing: The new lease standards directly affect how you report leases that are alleviating a debt. Accurately capturing your job costs will likely change, depending on what the cash flow of paid leases provide to your business.
While the new reporting standards do not change the core economics of your business, certain important finance ratios may shift. If your company currently has a number of off-balance sheet leases that, going forward, will be recorded on the balance sheet, it is a good idea to meet with your lenders and sureties about the potential changes in your reporting. A sudden increase in liabilities on a balance without prior warning or explanation may trigger cause concern with lenders, so it’s best to make sure everyone is on the same page. Depending on your situation, you may want to discuss updating the terms of any covenant to build in needed flexibility to prevent violations brought on by any potential future changes to accounting standards.
The new leases standard also will require lessees and lessors to provide additional qualitative and quantitative disclosures to help financial statement users assess the amount, timing, and uncertainty of cash flows arising from leases. These disclosures are intended to supplement the amounts recorded in the financial statements so that users can understand more about the nature of an organization’s leasing activities
What qualifies as a lease?
Overall, to be considered a or containing a lease, a contract must convey the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration or a period of time may be described in terms of the amount of use of an identified asset (for example, the number of production units that an item of equipment will be used to produce).
There are specific kinds of leases, however, that meet more exact standards:
- Must meet the following criteria at the commencement date
- The lease transfers ownership of the leased asset to the lessee on or before the end of the lease term
- The lease gives the lessee an option to purchase the asset and the lessee is reasonably certain to exercise that option.
- The lease term represents the major part of the remaining economic life of the leased asset. (However, if the leased asset is at or near the end of its economic life as of the beginning of the lease, this criterion is not applicable.)
- The present value of the sum 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.
- The leased asset is so specialized for a particular purpose that it is not expected to have an alternative use to the lessor when the lease is over.
- Any lease that does not meet the criteria of a finance lease, as previously discussed
Short term lease
- A lease that has a term of 12 months or less as of the commencement date and does not have a purchase option that the lessee is reasonable certain to exercise.
- A lessee may elect as an accounting policy, by class of underlying asset, to not recognize a right-of-use asset and lease liability for a short-term lease.
Right-of-use (ROU) asset
- The asset is the lease
- Lessee has control of asset and right to direct the assets uses measured as the sum of:
- the lease liability as measured at the beginning of the lease
- lease payments made to the lessor on or before the commencement date (less any incentives received)
- any initial direct costs that the lessee incurred
- In some instances, the right-of-use asset and the lease liability may be the same amount
- Amortized over the life of the lease
How do I know if I have control of a leased asset?
You must have both of the following:
- The right to obtain substantially all of the economic benefits from use of the identified asset
- The right to direct the use of the identified asset
What does lease liability include?
Lease liability is associated with ROU assets, where the asset is the lease. Liability is measured at the present value of the remaining lease payment, using a discount rate based on the rate implicit in the lease, if readily determinable.
Implicit rate is the discounted rate used by the lessor to determine the total value of the least. Essentially, the rate implied is what the loan would be if a lessee decided to purchase the ROU asset instead of utilize a lease.
Lease payments include:
- Fixed payments (less incentives paid or payable to the lessee)
- Variable lease payments that are dependent on an index or a specified rate
- Exercise price of a purchase option for the leased asset that is reasonably certain to be exercised
- Penalties for terminating the lease if the lessee is reasonably certain to exercise the termination option
- Certain fees paid by the lessee for structuring the transaction
- For lessees only, amounts probable of payment under residual value guarantees
Lease payment are made during the lease term which represents the non-cancellable period in which the lessee has the right to use the leased asset plus the periods covered by (a) an option to extend the lease if the lessee is reasonably certain to exercise the option; (b) a lease termination option if the lessee is reasonably certain to not exercise the option; and (c) an option to extend (or not to terminate) the lease that is controlled by the lessor.
Lease term is dictated by intent and if an event is reasonably possible.
What types of leases are covered under the new accounting standards?
Every type of lease your company is contracted under should be examined. Below are the most common leases that will need to be adjusted under the new standards:
- IT Equipment
- Office Equipment
- Fleet Vehicles
- Manufacturing Equipment Leases
- Construction Equipment Leases
- Building Leases
- Medical Equipment Leases
- Trucking and Transportation Leases
Are there special considerations for different industries?
In short, yes. There are special considerations for every industry, but especially for the manufacturing, construction and not-for-profit Corrigan Krause has a dedicated team for each industry, manufacturing, construction and not-for-profit, as well as a team for healthcare and dental, real estate and financial/professional services.
Who needs to comply?
Private companies and most not-for-profit organizations must start using the new lease accounting standards in annual reporting periods beginning after 12/15/2021.
When do businesses need to comply?
The effective date for the new lease standards has changed a few times. As it stands now, private companies and most not-for-profit organizations must start using the new lease accounting standards in annual reporting periods beginning after 12/15/2021. For example, if your year end is 12/31, you must adopt the new standards for your year beginning 1/1/2022 and ending 12/31/2022. For an entity with a 3/31 year end, the new lease standards are required for the fiscal year beginning 4/1/2022 and ending 3/31/2023. Leases that have terms of 12 months or less generally do not need to be included on the balance sheet, however. Additionally, capital leases are now referred to as finance leases.
What can I do to prepare for the new lease accounting standards?
The Corrigan Krause Lease Accounting Team created a helpful checklist to walk you through preparing for the new lease accounting standards. Click here to download the new lease accounting checklist.
Corrigan Krause Can Help
Corrigan Krause has a Lease Accounting Team ready to walk our current and new clients through the transition to the new lease accounting standards. If you’re a current Corrigan Krause client, reach out to your team any time to get started.