An ancient Chinese proverb states, “The best time to plant a tree was 20 years ago; the second-best time is now.”
This proverb can be applied to many aspects of life: Training for a marathon, remodeling your home or even adopting a new lease accounting standard.
New leasing guidance: Who’s impacted, what’s changing and why?
If you oversee the financial reporting for a private company, specifically one that produces financial statements in accordance with U.S. GAAP, now is the time to familiarize yourself with and transition to ASC 842, the new lease accounting standard issued by the Financial Accounting Standards Board (FASB).
Under the current accounting guidance, the future payments associated with certain lease arrangements and operating leases are excluded from the balance sheet. The new lease accounting guidance was issued with the intention of increasing transparency and comparability among companies by requiring all leases, including most operating leases, to be recorded on the balance sheet.
It’s important to note ASC 842 does not impact the ongoing amount and timing of rental expense recorded to the income statement attributed to an operating lease agreement. Rather, the impact is on the balance sheet and disclosures only. The new guidance is effective for annual reporting for fiscal years ending Dec. 31, 2022, and for interim reporting in 2023. Given the impending deadline, the time to act is now.
What is a lease?
A “lease,” according to ASC 842, is any asset where a payment is made in exchange for the right to control the asset for a defined period of time. The asset subject to the lease guidance could be a vehicle, warehouse facility or a copier within an office building.
Adopting the guidance: Balance sheet gross-up inputs
The new guidance requires a recorded right-of-use (ROU) asset to reflect the right to control an asset for an extent of time and requires a recorded lease liability to reflect the present value of future payments associated with the leased asset.
To record the ROU asset and lease liability, there are three inputs necessary for each operating lease:
• The payments for the right to use/control the asset being leased (lease payments).
• The period over which those lease payments will be made (lease term).
• Discount rate (the implied interest rate tied to lease payments over the lease term).
ASC 842 also requires enhanced financial statement disclosures which includes information from operating leases that are not required to be disclosed under the current accounting guidance. Familiarizing yourself with the disclosure requirements can help increase efficiency in the lease agreement review process to ensure you’re capturing key terms.
Embedded leases: Potential hidden leases?
Since all leases (operating and capital/finance leases) are recorded on the balance sheet under the new standard, the focus is on ensuring all leases have been identified. Unfortunately, determining the number of leases isn’t as simple as identifying all contractual agreements that state “lease” at the top.
Service contracts or agreements might contain provisions that allow the customer the right to control an underlying asset in addition to the service being provided. This is referred to as an “embedded lease.” Common examples include dedicated warehouse spaces within a third-party warehousing arrangement, specifically identified servers within a third-party cloud data storage arrangement or hardware within a telecommunications service arrangement.
To correctly record agreements containing an embedded lease requires dissection to determine the amount paid toward the right to use/control the underlying asset (lease portion) and the amount paid toward the service (non-lease portion) of the agreement. After reviewing your supplier contracts, you might discover you have more leases than you thought.
Financial statement implications: Financial statement ratios
ASC 842 results in balance sheet gross-up due to the recording of long-term assets, short-term liabilities and long-term liabilities which were not previously recorded. This causes a mismatch of current assets and current liabilities, and non-current assets and non-current liabilities.
Additionally, certain ratios might be impacted as well, including working capital ratio, quick ratio, total liabilities to total equity, debt service coverage ratio and return on assets. This could be an issue as stakeholders often evaluate the financial performance and health of a company based on financial statement ratios.
Management should review its debt/surety/bonding agreements, assess implications of the new guidance on relevant financial ratios, and begin conversations with stakeholders on how the new guidance will impact the evaluation of the company’s performance.
Overcoming transitional hiccups
To mitigate transitional hiccups, create a timeline for the new standard adoption process that includes the following:
• Determining implications of the new standard on debt covenants and other financial ratios.
• Exploring available lease accounting software solutions versus manual excel spreadsheets for the new standard and ongoing ASC 842 lease accounting.
• Identifying the population of all lease contracts, including embedded leases.
• Reviewing executed lease agreements and associated amendments for key terms from each lease.
• Determining discount rates for each lease.
• Inputting and reviewing the input accuracy of leasing and interest rate data into lease accounting software/excel spreadsheets.
• Drafting and reviewing enhanced lease disclosures for inclusion in financial statements.
Adopting the new lease accounting standard, ASC 842, will require significant time and effort for those overseeing the financial reporting. If that’s you, the best thing you can do is start now.