Lease Accounting for Lessees – ASC 842
Leasing is a vital activity for many organizations. It is a means of acquiring access to assets, obtaining finance, and reducing an organization’s exposure to the risks of asset ownership. The legacy accounting model has been criticized for failing to meet the needs of the users of financial statements because it does not always provide a faithful representation of leasing a transaction as they do not require lessees to recognize assets and liabilities arising from operating leases. As a result, there has been a longstanding request from many users of financial statements and others to change the accounting requirements so that lessees would be required to recognize those assets and liabilities.
In February 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2016-02 (Topic 842) Leases. Central to ASC 842 is the idea that lessees should recognize the assets and liabilities arising from leases on their balance sheets.
Public companies adopted these new lease accounting standards on January 1, 2019. The updated guidelines are now set to take effect for private entities, starting with fiscal years beginning after December 15, 2021 (i.e., effective for calendar year-end companies as of January 1, 2022).
While the guidelines for lessors largely remain the same, the new lease accounting rules are designed to encourage more accurate accounting for lessees. Knowing what to expect can help your company prepare for the transition.
Applying ASC 842 Lease Accounting Rules
Applying ASC 842 guidelines is a five-step process that begins with determining whether a contract contains a lease.
Broadly speaking, a lease exists if:
- A contract includes an identified asset
- You have the right to obtain economic benefits from the use of the asset
- You have the right to control and direct the use of the asset
The standard applies to leases that are longer than 12 months. Not covered under the standard are intangibles, rights to explore nonrenewable natural resources, biological assets (e.g., timber), inventory, and assets under construction, to name a few. Month-to-month leases also may not avoid the standard if it is reasonably certain that the lessee is economically incentivized to renew the lease beyond 12 months.
After determining whether a contract contains a lease, the next step is identifying the separate lease components within the agreement. Specifically, this includes categorizing the lease and non-lease components. A typical example is an equipment lease combined with maintenance services. Other contracts may include multiple lease components, such as the lease of a port consisting of land, buildings, and equipment.
Once these components are identified, appropriate consideration needs to be allocated to the separate elements. Lessees then determine lease classification between operating or finance. A finance lease exists when any of these five criteria apply:
- Ownership of the underlying asset transfers to the lessee by the end of the lease term
- Lessee is granted an option to purchase the underlying asset, which the lessee is reasonably certain to exercise
- The lease term is for the major part of the remaining economic life of the underlying asset
- The present value of the sum of the lease payments represents substantially all of the asset’s fair value
- The underlying asset is of such a specialized nature** that it is expected to have no alternative use to the lessor at the end of the lease term
If none of these conditions are met, then it’s considered an operating lease.
The final step is calculating the value of lease liabilities and right-of-use assets.
**customized exclusively for the lessee
Determining the value of Lease Liability & Right-of-use (ROU) asset
The lease liability represents a company’s obligation to make lease payments. It is measured at the present value of future lease payments by discounting the liability over the lease term, using the discount rate, and recording it on the balance sheet.
For assets, per the new guidance, we record the right to use the asset (as in, the right to use the vehicle instead of the actual asset itself). To calculate the value of a right-of-use-asset, we would first need to determine the lease liability, add lease payments made at or before the commencement date, initial direct costs paid at or before the commencement date, and deduct incentives received at or before the commencement date. If the company has any existing deferred rent balances, that is also subtracted from lease liability to get ROU Asset.
Impact of ASC 842 on the Financial Statements
Despite recording both the operating and finance leases on the balance sheet, each lease type’s respective expense recognition pattern would differ. Operating leases, for instance, require lease expense to be recognized on a straight-line basis over the term of the lease. On the other hand, finance leases require the lessee to recognize both interest expense and amortization expense.
As a result, the lessee will usually recognize a more significant expense in the initial phase of the lease when it has a finance lease.
ASC 842 requires disclosure of both qualitative and quantitative information about leases. The ROU assets and lease liabilities must be presented by lease classification (operating versus finance) on a gross basis and on separate line items from one another. A few of the specific disclosures necessary are discussions covering the lease arrangements, descriptions of significant judgments made, details of lease costs reported on the income statement, analysis of discount rates, and remaining lease terms.
How to Approach ASC 842
There are two methods your organization can use to adopt the ASC 842: the full approach and the modified approach method.
- Full Approach
The full, or comparative, approach uses a retrospective application to each prior reporting period presented in the financial statements, with the cumulative effect of the initial application being recognized at the beginning of the earliest comparative period presented (subject to other transition requirements).
- Modified Approach
This method relies on retrospective application at the beginning of the adoption period, through a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption (difference between added ROU Assets and Liabilities). Under this transition method, the application date should be the beginning of the reporting period in which the entity first applies the guidance.
Using the full approach would undoubtedly require more time and effort than the modified retrospective approach. Adopting the latter would not require companies to adjust comparative amounts for the prior period; instead, they provide disclosures in the notes when transitioning to ASC 842.
What You Can Do to Prepare for ASC 842
With the clock ticking, it’s essential to address the upcoming lease accounting changes sooner rather than later. To make this process easier, here are the key steps we recommend organizations start taking right away:
- Develop a plan and timeline to implement the new standard
- Prepare an initial inventory of lease data
- Implement processes, systems, and controls to maintain inventory of lease data
- Review lease agreements and determine the accounting under the new rules
- Calculate the effects of adopting the standard on the entity’s financial statements
- Communicate the effects to stakeholders
- Educate employees on the new standard
- Evaluate any effects on the terms used in future leases
- Understand the tax implications
- Update accounting policy documents
- Draft disclosures to meet new disclosure requirements
The use of software is highly recommended to track leases, owing to the complexities of the calculations involved. The software would manage lease inventories and even automatically report monthly journal entries and financial statement disclosures. Utilizing a software will drastically reduce the amount of time spent implementing the standard, not to mention reducing the time and fees related to auditing leases.
Here at Aldrich, we offer a subscription through LeaseCrunch and will be more than happy to assist with implementing the software as well.
Aldrich is Here to Help
Following this checklist can help ensure compliance and identify any potential gaps or shortcomings with your current lease accounting practices. If you need help getting your company ready ahead of the new lease accounting rules, we’re here to help. Contact your Aldrich Advisor today for more information.