In February 2016, the Financial Accounting Standards Board (“FASB”) issued its new guidance on lease accounting (Item 842), referred to as ASC 842, in ASU No. 2016-02, Leases (Item 842). The standard requires lessees to provide all leases (with lease terms greater than 12 months at the commencement date) the following: a) a lease liability, which is a lessee’s obligation to make lease payments under a lease, measured on a discounted basis; and b) a right-of-use asset, which is an asset that represents the lessee’s right to use or control the use of a specified asset for the lease term.
Public companies have already acquired ASC 842.
Privately held calendar year-end companies are required to adopt ASC 842 effective January 1, 2022. Privately held fiscal year ending companies must adopt ASC 842 in fiscal years beginning after December 15, 2021.
If you have not yet adopted the leasing standard, consider these steps as you assess the impact of ASC 842 on your business:
1. Identify your leases. Some common leases are for offices or buildings, copiers, mail machines, vehicles, or equipment.
2. Evaluate embedded lease contracts.
3. Evaluate the leases to determine lease classification as operating or finance leases.
- Finance leases meet one or more of the following criteria:
- The transfer of ownership takes place at the end of the rental period.
- The lease contains a provision that gives the lessee the option to purchase the asset and there is a reasonable certainty that the option will be exercised.
- The lease term represents most of the asset’s economic life.
- The present value of the lease payments over the lease term, calculated at the inception of the lease, is substantially equal to or greater than the total fair value of the asset.
- The leased item is so specialized that it has no alternative use for the lessor.
b. Operating leases are all leases that do not meet the criteria of a finance lease.
4. Select a transition method:
- Comparative Method – retrospective restatement of prior comparative periods in financial statements (all financial data presented would reflect leases in accordance with ASC 842).
- Effective Date Method – accounting for leases in accordance with ASC 842 from 1 January 2022 with no prior year adjustment. The prior year financial statements would reflect leases in accordance with ASC 840.
5. Consider practical expedients:
- The package of practical expedients that must be chosen together.
- No reassessment of lease classification for existing or expired leases.
- No reassessment of embedded leases for existing or expired contracts.
- No reassessment of initial direct costs.
b. A look-back that allows lessees to make assumptions about the lease term and the value of the right-of-use asset at inception based on current information.
c. Easements – Elect not to reevaluate existing or expired easements as defined by ASC 842 as a leasehold.
i.e. Short-term lease exemption, which allows lessees not to capitalize leases with a lease term of 12 months or less on the lease commencement date (rather than the acquisition date).
e. Combine leasing and non-leasing components.
6. Determine the discount rate to be used for present value calculations. Private corporations may consider the applicable federal interest rate or use the corporation’s incremental borrowing rate as defined.
7. How many leases do you have?
- If you have more than a handful of leases or complex agreements, consider using software that does the calculations for you. Lease software does several things. Lease information is stored in a single location and is easily accessible. Reports can be run for both interim and year-end periods. Information for required footnotes is calculated by the leasing software. The reports from the leasing software aggregate the leases to calculate the right-of-use asset, finance or operating lease liability, lease expense, interest expense, and depreciation expense.
- If you have fewer than a handful of non-complex leases, an Excel template may be appropriate to do the lease calculations. The Excel templates are generally at a specific point in time. So when an interim report is needed, the Excel templates need to be updated.
8. Complete the lease calculations and make the necessary adjustments to the general ledger.
9. Calculate your financial covenants according to loan or other agreement requirements. Discuss the implications of ASC 842 with your banker before year-end, particularly if you require a covenant waiver.
10. Write the necessary footnotes for your financial statements. ASC 842 has significantly more disclosure requirements than previous guidance. The footnotes must include a description of the leases, explanations of variable lease payments, terms and conditions of options to extend or terminate the lease, residual value guarantees, subleases, significant assumptions and judgments made, treatment of lease costs, future maturities, policy choices, and practical tools. Consider these requirements when abstracting your leases.