Even though the Financial Accounting Standards Board (FASB) pushed back the deadline for private companies and not-for-profit organizations to comply with new lease accounting rules — now applicable for fiscal years beginning after December 15, 2021, and interim periods of fiscal years beginning after December 15, 2022 — organizations cannot afford to let more time pass by before acting on implementation.
The FASB's Accounting Standards Update (ASU) 2016-02 ("Topic 842" or "the new standard") applies to both lessees and lessors and it brings significant changes to balance sheets. The extra time granted by the FASB reflects the mammoth task ahead, which will require more work, more resources and more time than most businesses realize.
UNDERSTANDING THE NEW STANDARD: LEASE ACCOUNTING FREQUENTLY ASKED QUESTIONS
What is Lease Accounting (ASC 842)?
ASC 842, Leases, provides the financial accounting and reporting requirements for lessees and lessors. This standard establishes the right-of-use asset model, which shifts from the risk-and-reward approach to a control-based approach. Under the new standard, lessees will recognize an asset on the balance sheet, representing their right to use the leased asset over the lease term and recognizing a corresponding lease liability to make the lease payments. The lease liability is based on the present value of future lease payments using a discount rate to determine the present value based on the rate implicit in the lease, if readily determinable, or the lessee's incremental borrowing rate. As a result, a lessee's operating lease accounting model will change significantly. Additional complexity of the new standard requires the lease arrangements to be classified as either finance leases or operating leases.
What Changes Can I Expect?
Finance leases will separately recognize interest expenses on the liability and amortization expense on the right-of-use asset. 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 liability is reduced. Operating leases will recognize lease expense on a straight-line basis over the lease term as a single line item in operating expenses in the income statement.
For lessor accounting under ASC 842, a sale and related profit are recognized upon the commencement of the lease only when the arrangement transfers control of the underlying asset to the lessee. The changes in the new guidance are aligned with the new revenue recognition standard, ASC 606, as leasing is fundamentally a revenue-generating activity for lessors. ASC 842 also requires additional disclosures related to the lessor's exposure to asset risk and credit risk. Lessors will classify the lease as a sales-type lease, direct finance lease or operating lease.
ASC 842 provides various practical expedients for the lessee and the lessor— for example, non-separation of lease and non-lease components, short-term leases, capitalization thresholds, hind-sight and land easement.
ASC 842 also provides guidance on determining whether an arrangement contains an embedded lease, whereas an explicit or implicit asset identified in the contract is controlled or used by the lessee.
What Challenges Can I Expect?
This standard represents a wholesale change to lease accounting; as a result, many entities will face significant implementation challenges such as:
- Not identifying embedded leases in arrangements.
- The number of arrangements that were previously not identified as leases may now be identified as meeting the definition of a lease or embedded lease.
- Existing systems and processes may need to be modified or enhanced in order to provide the information necessary to address the new reporting and disclosure requirements.
- Multiple departments across the organization will be affected by this standard, including information technology, tax, legal, treasury, and financial planning and analysis, among others.
- Ongoing efforts might be more significant than the initial implementation effort.
This standard includes extensive disclosures intended to enable users of financial statements to understand the amount, timing and judgment related to a reporting entity's accounting for leases and the related cash flows. This standard requires disclosure of both qualitative and quantitative information about leases.
Why is Lease Accounting Important?
ASC 842 establishes the principles that lessees and lessors should apply to report useful information to users of the financial statements about the amount, timing and uncertainty of cash flows arising from a lease.
Who Does Lease Accounting Affect?
Lease accounting affects all entities that lease assets, including real estate, airplanes and equipment. The standard excludes leases of intangible assets; leases to explore for or use nonregenerative resources; and leases of biological assets, inventory and assets under construction.
When Is the Deadline To Adopt the Lease Accounting Standard?
In June 2020, as a result of the COVID-19 pandemic, the FASB extended the deadline to implement the new standards on leases for entities in the "all other" category and public not-for-profit entities that had not yet issued their financial statements.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.