In February 2016, the Financial Accounting Standards Board (“FASB”) issued its new lease accounting guidance in ASU No. 2016-02, Leases (Topic 842), called ASC 842. The standard requires lessees to recognize for all leases (with terms of more than 12 months at the commencement date) the following: a) a lease liability, which is the lessee’s obligation to make lease payments arising from a lease, measured on a basis of discount, and b) an active right of use, which is an asset that represents the lessee’s right to use or control the use of a specific asset during the term of the lease.
Public companies have already adopted ASC 842.
Private companies ending the calendar year must adopt ASC 842 on or after January 1, 2022. Private companies ending the fiscal year must adopt ASC 842 in the fiscal year beginning after December 15, 2021.
If you have not yet adopted the leasing standard, consider these steps when evaluating the impact of ASC 842 on your business:
1. Identify your lease agreements. Some common leases are for offices or buildings, photocopiers, postal machines, vehicles, or equipment.
2. Evaluate implicit lease contracts.
3. Evaluate leases to determine the classification of the lease as an operating or finance lease.
- Finance leases meet one or more of the following criteria:
- The transfer of ownership occurs at the end of the lease term.
- The lease agreement contains a provision that the lessee has the option to purchase the asset, and it is reasonably certain that it will exercise that option.
- The lease term represents the majority of the economic life of the asset.
- The present value of the lease payments over the lease term, calculated at the inception of the lease, substantially equals or exceeds the entire fair value of the asset.
- The leased asset is of a specialized nature such that it has no alternative use for the lessor.
b. Operating leases are any leases that do not meet the criteria for a finance lease.
4. Select a transition method:
- Comparative method: retroactively adjust prior comparative periods in the financial statements (all financial statements presented would account for leases under ASC 842).
- Effective Date Method: Account for leases under ASC 842 beginning January 1, 2022 without adjusting for prior years. Prior year financial statements would account for leases under ASC 840.
5. Consider practical expedients:
- The package of practical files, which must be chosen together.
- There is no reassessment of lease classification for existing or expired leases.
- No reassessment of implicit leases for existing or expired contracts.
- There is no reassessment of initial direct costs.
b. Hindsight, which allows lessees to make assumptions about the lease term and right-of-use asset value at inception using current information.
C. Land Easements: Choose not to reassess existing or expired land easements under the definition of a lease under ASC 842.
d. Short-term lease exemption that allows lessees not to capitalize leases with a term of twelve months or less at the lease commencement date (not the adoption date).
me. Combine lease and non-lease components.
6. Determine the discount rate to be used for present value calculations. Private companies may consider the applicable federal rate or use the company’s incremental borrowing rate as defined.
7. How many leases do you have?
- If you have more than a handful of complex leases or arrangements, consider using software that does the math for you. Leasing software accomplishes several things. Leasing information is kept in one place and can be easily accessed. Reports can be run for both interim periods and year-end. The leasing software calculates the information for the required footnote disclosures. Leasing software reports aggregate leases to calculate end-use right-of-use asset, finance or operating lease liability, lease expense, interest expense, and depreciation expense.
- If you have less than a handful of non-complex leases, an Excel template might be suitable for performing your lease calculations. Excel templates are generally at a point in time, so if an interim report is needed, the Excel templates will need to be updated.
8. Complete the lease calculations and record the necessary adjustments in the general ledger.
9. Calculate your financial covenants as required by any loan or other agreements. Discuss the impact of ASC 842 with your banker before the end of the year, especially if you’ll need a covenant exemption.
10. Write the required footnotes for your financial statements. ASC 842 has significantly more disclosure requirements than previous guidance. Footnotes should include a description of the leases, an explanation of variable lease payments, the 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 expedients. Keep these requirements in mind when abstracting your leases.