Whether you are ready or not, the ASC 842 standard for GAAP lease accounting is here—and the time is now to prepare your clients for its implications.
What exactly does this new standard mean?
The new ASC 842 standard for GAAP lease accounting requires all leases longer than 12 months to be recorded as assets and liabilities on balance sheets, and this must be implemented for nonpublic companies for fiscal years beginning after Dec. 15, 2021.
Implementing the new standard requires companies to categorize all leases as both liabilities and right-of-use assets and will have significant impacts on the balance sheets of many organizations.
Getting your clients ready now, before the busy season arrives, is critical to ensuring that you have the time and resources to assist clients without having to outsource the work or raise your fees.
Fortunately, Financial Accounting Standards Board (FASB) provides practical expedients to simplify the new standard and lighten the burden of implementing it. Understanding how to apply these mitigating tools is key to easing the transition.
Leases are complicated. Analysis of your leases and understanding the context of the new standard can take some time.
When addressing leases that existed before ASC 842—those that need to be transitioned—be sure to apply the practical expedients provided by FASB to these transitional leases.
For transitional leases, if you have good software, there really are only six basic pieces of information about each lease that you need on hand to prepare for transition:
- 1. Start Date — This is the initial application of the standard, so Jan. 1, 2022, for companies operating on a calendar year basis.
- 2. Lease Term — You know the start of the lease, so when does the lease end? If you as the lessee can renew or terminate the lease, assess whether you are reasonably certain to renew or terminate based on your economic incentive to do so. That will determine the end date of the lease for accounting purposes.
- 3. Discount Rate — FASB allows nonpublic companies to use a risk-free rate. The challenge with the risk-free rate is that it is lower than your collateralized borrowing rate, therefore increasing your lease liability. The good news? The FASB allows you to determine your discount rate methodology by asset class. As a result, you can use the easier risk-free rate for lower dollar value leases where difference is less material, then spend time obtaining your collateralized borrowing rate for larger leases (i.e., office space).
- 4. Operating Lease or Finance Lease — Ohm explains: “FASB provides a practical expedient that allows you to simply use the pre-ASC 842 lease classifications for transition leases. If your lease was correctly classified as an operating lease before, it is an operating lease now. Similarly, if you had a capital lease before, it is a finance lease now.
- 5. Existing Balances — This refers to the amount on your balance sheet as of the initial application date of the lease accounting standard. For example, operating leases might have a deferred rent balance from pre-ASC 842. There is no concept of a deferred rent balance in ASC 842. Instead, it all flows through the ROU asset.
- 6. Remaining Lease Payments — Your remaining lease payments must be included and considered.
People assume that this is going to be a lot of work, so they put it off to the last minute. With these six pieces of information and robust software, leveraging FASB’s practical expedients is much more straightforward.
Another reason why getting ahead of the new standard is important? Debt covenants.
Many private companies follow GAAP accounting because they have a bank loan. Adding lease liabilities could cause them to be in violation of some of their debt covenants.
Fortunately, debt covenants are changeable, but banks are expecting clients to come to them if they think they are going to be in violation. Knowing where you’re at risk of a violation requires getting started early to ensure that you don’t end up with a violation.
Applying the practical expedients provided by FASB
Pay attention to the resources provided by FASB, Ohm encourages, when preparing your transitional leases for the new standard.
One area that should be of particular focus is the discount rate. You will want to look at the length of the term for the discount rate, and decide whether you want to use the rate for the remaining term or for the original term of the lease. Once you’ve selected a methodology, it must be applied to all leases.”
It is important to note that using a rate for the full lease term is likely lower, thereby resulting in a lower liability added to the books.
When addressing leases that existed before ASC 842—those that need to be transitioned—be sure to apply the practical expedients provided by FASB to these transitional leases.
Materiality should also be considered. For your more material (read: large) leases, spend the time to determine an appropriate discount rate. The lease standard says that you are supposed to use the rate implicit in the lease, if it is readily discernible. This is rarely the case.
The discount rate is going to take a little time to calculate, as it needs to be the collateralized borrowing rate if a company were to borrow money to buy the leased assets for a certain period of time.
This is only important for material assets like an office lease where using a higher discount rate will be a benefit. For smaller leases, Ohm encourages using the practical expedient of the risk-free rate. For operating transitional leases, that would be the rate as of Jan. 1, 2022.
Related Party Leases
Recently, there has been a lengthy discussion about how related party leases are impacted by the new standard. For these leases, the new standard must be applied to the legally enforceable provisions of the lease.
FASB is in the process of issuing more guidance about this, but one of the discussion points is they seemed to be surprised that organizations are engaging with legal counsel on this. That does not seem to have been the intent and guidance will likely emphasize that this is not necessary.
What is critical about all of this is that financial statement users—most likely banks—have a clear and transparent understanding of the business and its leases.
Don’t think that if you have only one lease, you don’t need to do this. If you have even a single lease, this applies to you.
Getting clients to be proactive and to understand the impact of the new lease standard is something CPA firms should be focused on now. Fortunately, there are tools to help uncover leases that need to be transitioned and addressed.
Software tools like an embedded lease identifier can ensure that a comprehensive audit of all leases is done—and that no surprises will pop up down the road.
Remember, it doesn’t have to be called a lease to be considered a lease under the new standard. I can’t emphasize enough the importance of getting ahead of this now to both protect resources and ensure that clients are prepared for the transition.
Ane Ohm is co-founder and CEO of LeaseCrunch, a software company dedicated to simplifying lease accounting.
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