The new standard requiring all leases longer than 12 months to be recorded on balance sheets is now in effect for nonpublic companies with a fiscal year beginning after Dec. 15, 2021.
To implement the new standard, organizations must identify all leases and book them as liabilities and right-of-use assets, which will have significant impacts on the balance sheets of many organizations.
While this may sound daunting, don’t worry! There are tips and tools to simplify implementing the new standard.
Learn what the new standard means for your business or clients
First comes understanding the basic concepts of the new standard.
The definition of a lease changed under ASC 842. Under the new definition, a contract contains a lease if it conveys the right to control an identified asset for a period of time in exchange for consideration. As a result, a contract may require lease accounting even if it isn’t called a lease.
There are also key terms to know, starting with lease vs. nonlease components, lease liability and ROU asset (a lessee’s right to use an asset over the course of a lease).
- Lease components are costs related to the right to use an identified asset, such as rent paid to use part of a building. Nonlease components may be associated with the asset but are not integral to its use, such as common-area maintenance (CAM) payments.
- Lease liability is fairly straightforward: the present value of remaining lease payments (the payments considered a lease component) over the lease term.
- ROU asset starts with the lease liability, adding initial direct costs paid and subtracting lease incentives received.
ASC 842 can have a significant impact on an organization’s financial statements. For many organizations, the only lease might be office space that, as an operating lease, only passed through the income statement under the previous standard. This change impacts long-term assets, as well as both long- and short-term liabilities, so adding a large lease can also impact your debt covenants.
Identify the lease portfolio
This seems like common sense, but leases are rarely managed in a central department for many organizations. The best way to prepare is:
- Review your expense accounts for payments that potentially contain a lease.
- Determine if contracts contain embedded leases. (A free embedded lease identifier can help.)
- Abstract each lease contract.
- Identify data gaps and decisions required around important topics, like the reasonably certain lease term. For each contract, do you have an economic incentive to renew or terminate, if you have that option?
Policy elections: discount rates and materiality
Because the lease liability is the present value of future lease payments, you must know which discount rate to apply. While the standard requires using the rate implicit in the lease when readily determinable, this rate is rarely known.
Nonpublic companies then have the option of using an incremental borrowing rate or the risk-free rate, and this option can be made by asset class. The incremental borrowing rate is generally more difficult to calculate, but results in a lower lease liability and ROU asset. Organizations tend to use the incremental borrowing rate for their larger leases, like office and warehouse space, and the risk-free rate for smaller leases, like vehicles and photocopiers.
While materiality isn’t a prescribed policy election, it is an important judgment decision.
The international standard on materiality states that any lease under $5,000 is immaterial. FASB specifically excluded a materiality limit, leaving materiality decisions up to you. When determining your approach to materiality for leases, consider the following points:
- Think about materiality as the full lease liability, not just the monthly payment amount.
- Adding leases to the balance sheet could have a material impact on day one. This could adversely affect your loan covenants and debt ratios, which could impact banking relationships if this isn’t addressed with your bank before issuing your financial statements.
- Avoid dismissing certain classes of assets as immaterial before conducting an analysis. We know of one public company that had decided its vehicle leases couldn’t be material and therefore did not include them in its lease accounting implementation process. A new controller reviewed the contracts and discovered they were material, resulting in an unwanted, but necessary financial statement correction.
- For organizations with many smaller leases, assess materiality both individually and in aggregate.
- Document materiality decisions for your CPA firm.
Documentation
Implementing the new lease standard requires numerous decisions that need to be documented and retained for reference by your CPA firm and your team in the future.
For individual leases, you have the agreement itself, any amendments, your reasoning for the lease term, lease classification and discount rate applied. Using a system that lets you store these documents as part of the lease record will save a lot of time in the long run.
For your organization, you need to make and document a number of policy elections. Using a policy election template can help guide you through the decisions you’ll need to make related to policy elections and practical expedients.
Set up the right systems and tools
No matter how you track your leases, the following actions will streamline the implementation process.
- Set up a new group of GL accounts before implementing the new lease standard. When creating these accounts, know that ROU assets and long- and short-term lease liabilities for finance and operating leases should be recorded separately.
- Consider software to simplify workflow and assure calculation accuracy. If you have lease data in a spreadsheet already, make sure bulk imports are available.
- Lastly, review maintenance. Decisions that were previously decentralized now need to be communicated to accounting. That means lease modifications and new leases need to be properly conveyed in the future. Open these lines of communication right away because these habits can be difficult to change.
Evaluating transition leases
A transition lease is one that started before the initial application date of the new lease accounting standard, which is the first date as of which the new standard is applied in your financial statements. For fiscal years ending Dec. 31, 2022, the initial application date is likely Jan. 1, 2022.
The FASB provided practical expedients to simplify implementation for transition leases, which most organizations elect to use. Electing the practical expedients means:
- Contracts properly identified as leases under the previous standard don’t have to be reassessed as leases under the new standard, including leases that expired during the year.
- Lease classifications for transition leases can carry forward from the old standard. An operating lease continues to be an operating lease, and a capital lease is now a finance lease.
- While the definition of an initial direct cost has changed, you don’t need to reassess this for transition leases.
What can be done with existing balances from the old standard? This is one accounting standard change where you will almost never make an adjustment to equity. Instead, the deferred rent for an operating lease is netted to the beginning ROU asset for that operating lease. Similarly, capital lease assets and liabilities should be netted to the beginning ROU asset for what is now a finance lease.
Last but not least
Do not underestimate the time it takes to implement the new lease standard! Tools and expertise can help ease the burden of your transition. You are not in this alone!
