Impacts of the New Lease Standard, Topic 842
The new lease standard, ASC Topic 842, is effective for privately held companies with fiscal years beginning after December 15, 2021. So, for companies with a fiscal year-end effective for 2022.
We’ll discuss some of the main provisions of the new standard as contrasted with prior accounting requirements at a high level. The full presentation on the Brown Edwards YouTube channel includes more details and examples of the impact of these significant changes.
What is the goal of the new standard?
In the past, assets and liabilities related to the leases were not necessarily reflected on the balance sheet. The new standard will require the presentation of those missing line items in addition to expanded disclosures.
A lease can exist in an agreement or contract, specifically, where an entity has a right to control and use identified assets. Control principally means the entity has the ability to realize the economic benefits from using that asset and has the right to direct the use of that asset. Within the standard, there is discussion and examples of what the economic benefits from the use of an asset are. Additionally, there are examples of directing the use of the asset. In addition to control, there are examples in the standard of how to determine if an entity has use of a specified asset.
All leases with a term greater than 12 months will be required to be presented on the balance sheet except for specific exclusions such as short-term leases, intangible assets and other items specified in the standard.
On the balance sheet entities will be required to present Right-of-Use (ROU) lease assets and lease liabilities.
Why does the standard matter?
There are many reasons why the changes to this standard are important. First, it’s going to change the look of our financial statements quite a bit as discussed above. There will be updated required disclosures in the footnotes to the financial statements including items not previously disclosed under the old standards related to leases.
Second, entities will need to track lease-related assets and liabilities either in a separate database or by some other means. This in turn could affect internal controls and internal policies related to the review and approval of such leases.
Third, working capital and working capital ratios will change which could, in turn, affect debt covenants or bonding limits based on how lease assets and lease liabilities are classified. Entities may look harder at the decision to buy versus lease assets. A re-evaluation of job costing and/or budgeting techniques may also be required.
Entities with a large number of operating leases will be most affected by this standard, however for entities with a number of capital leases the change won’t be as significant.
Let’s begin by defining what a lease is. Topic 842 has a slightly different definition from the previous standard.
Under the old standard, a lease was an agreement, which conveyed the right to use, property plant, witness, like land or depreciable assets, usually for a stated period of time.
Under the new standard, a lease is a contract or part of a contract that conveys the right to control the use of an identified property, plant or equipment, for a period of in exchange for consideration.
There are a few key points here in the definition. The new definition specifically refers to a contract, and a lease can be viewed as part of a contract. The definition of a contract includes both written and oral contracts. If there is a question of whether or not a contract exists, you should reference Topic 606, Revenue Recognition, which addresses this topic. The new definition also highlights the right to control within the context of the lease and specifically mentions in exchange for consideration. Under the new standard, the critical determination is whether or not a contract whether written or oral, contains a lease.
As with the previous standard, two types of leases will be applicable; finance leases and operating leases. A finance lease, formerly referred to as capital leases, are those leases where the lessee effectively owns the asset by the end of the lease term. Operating leases are those leases where the asset will revert back to the lessor at the end of the lease term.
One of the most significant differences is that under the new standard both finance leases and operating leases are required to be presented on the balance sheet whereas in the past, operating leases were not.
In the standard, there are criteria to help you determine whether you have a finance lease or an operating lease.
A lease will be classified as a finance lease if it meets one of the following criteria:
- A lease transfers the ownership of the asset at the end of the term.
- The lease contains a purchase option that is “reasonably certain” to be exercised by the lessee.
- The lease term is a major part of the remaining economic life of the asset.
- The present value of our expected lease payments equals or exceeds substantially all of the fair value of the asset, at the time of inception.
- The underlying asset is so specialized in nature that only the lessee can use it.
If the lease doesn’t meet any of these criteria, it will be classified as an operating lease.
My full presentation presents more detail about short-term leases, how “reasonably certain to be exercised” is determined, and how to calculate the “major part of the remaining economic life” and “substantially all of the fair value.”
ACCOUNTING FOR LEASES
Below is a representation comparing both finance and operating leases in the financial statements:
|Record a right-of-use asset and lease liability||Record a right-of-use asset and lease liability|
Interest expense is determined using the effective interest method. Amortization is recorded on the right-of-use asset (usually on a straight-line basis). The periodic expense at the beginning of the lease term will generally be greater than the corresponding cash payments but will decline over the lease term as the lease liability is reduced
|Lease expense is recorded on a straight-line basis over the lease term by adding interest expense determined by using the effective interest method to the amortization of the right-of-use asset. Unlike a finance lease, amortization of the right-of-use asset is calculated as the difference between the straight-line expense and the interest expense on the lease liability for a given period|
|Interest and amortization expenses should generally be presented separately in the income statement||
Lease expense is presented as a single line item in operating expense in the income statement
|The right-of-use asset is tested for impairment in accordance with ASC 360||The right-of-use asset is tested for impairment in accordance with ASC 360|
Statement of Cash Flows
|Repayment of principal should be classified as financing activities||Operating lease payments should be classified as operating activities|
|Interest on the lease liability should be classified in accordance with guidance related to interest in ASC 230||Operating lease payments that are capitalized as a cost bringing another asset to intended use should be classified as investing activities|
|Variable lease payments should be classified as operating activities|
Deferred taxes - The new rules require operating leases to be recorded as right-of-use (ROU) assets with a corresponding lease liability, consequently grossing up the balance sheet. This will result in additional recordkeeping to track book-to-tax items.
State and local taxes - Because the new standard requires ROU assets related to operating leases to be recorded on the same line item as underlying assets, property factors (such as plants and equipment) may appear to be increased on a company’s balance sheet. Ultimately, this will affect state apportionment for companies that have activity in states that include property factors when calculating apportionment percentage.
Property taxes - Depending on the tax jurisdiction, ROU assets may be considered tangible personal property and will therefore need to be included in property tax filings.
Sales and use tax - Companies will need to determine whether a state will treat a lease transaction as a taxable purchase.
Preparing Your Company
Are you ready for implementation?
The most significant risk is simply determining what leases exist. For entities that are large and non-centralized, determining what contracts exist and potentially contain leases will be a significant undertaking. Existing contracts will need to be analyzed and new contracts will as well to determine if lease characteristics exist. Another risk will be contracts that contain embedded leases. These tend to be agreements that bundle service and a device or equipment.
When analyzing leases, lease and non-lease components of the contract should be accounted for separately. Non-lease components can be a number of things such as common area maintenance or security charges in a real estate lease. If leasing part of a building, for example, these types of non-lease components don't contribute to the use of the building asset and would simply be an expense when incurred rather than included in the initial lease calculation.
Make preliminary calculations of the lease assets and lease liabilities to determine how financial statements will change. Discuss these results with bankers and bonding agents and the impact on covenants. Liabilities, in general, will increase so working capital and debt to equity ratios will be affected. Indirect direct job cost allocations could be impacted too.
It may be worth considering separate tracking software when necessary. A significant amount of effort will be required at implementation as the data is gathered, but this will be an ongoing compliance issue, both in record keeping and review of potential leases as they arise.
Entities need to implement processes and system controls to maintain an inventory of lease data. Decisions on responsibility for review of new agreements, the accounting on these agreements, and approval will all need to be considered.