Mallory Vincent, CPA, MBA •
FASB ASC 842, Leases, has changed the way private companies account for leases by replacing the US GAAP standard under ASC 840. In Part I of this blog, we focused on planning for this new standard by doing the following: 1) locating all your lease contracts and documents and get them signed, if required; 2) creating an implementation team to perform a completeness review to ensure all leases have been identified, and 3) reviewing internal controls and set up a process for accumulating lease information. Now that ASC 842 is here, it is time to put that planning to use. How, you may ask? Well, let’s start by answering some commonly asked questions.
FASB ASC 842, Leases, has changed the way private companies account for leases by replacing the US GAAP standard under ASC 840. In Part I of this blog, we focused on planning for this new standard by doing the following: 1) locating all your lease contracts and documents and get them signed, if required; 2) creating an implementation team to perform a completeness review to ensure all leases have been identified, and 3) reviewing internal controls and set up a process for accumulating lease information. Now that ASC 842 is here, it is time to put that planning to use. How, you may ask? Well, let’s start by answering some commonly asked questions.
What do you look for in your lease contracts?
First, look at the terms of the contract to ensure it meets the definition of a lease. Under ASC 842, a lease should include 1) an identified asset; 2) the right to control the use of that asset; 3) a period of time, and 4) consideration in exchange for use of the asset. After determining that a contract contains a lease, identify the separate lease and non-lease components under the contract and allocate the consideration to the various components.
How is a lease recorded under the new lease accounting standard?
While ASC 842 retains the two-model approach to classifying leases as operating or finance (formerly capital leases), the key provision is that lessees recognize all leases on the balance if the lease term is greater than 12 months. When a lessee records a lease on the balance sheet, it will recognize a right-of-use (ROU) asset with an offsetting entry to recognize a lease liability based on the present value of the future lease payments. The discount rate used will be based on the rate implicit in the lease, if readily determinable; otherwise, the lessee’s incremental borrowing rate will be used.
For expense recognition, the lessee would recognize lease expense on a straight-line basis over the lease term for an operating lease. However, for a finance lease, the lessee would recognize both interest expense (using the effective interest method) and amortization expense. As a result, the expense recognized by the lessee will be higher in the earlier life of the lease for a finance lease than for an operating lease.
What is the short-term lease exception?
A lessee may elect, as an accounting policy, not to record leases with terms of 12 months or less on the balance sheet. Instead, the lessee records the payments in the income statement on a straight-line basis over the lease term. The short-term lease exception is available only if the lease term, which includes periods covered by renewal options whose exercise is reasonably certain, is less than 12 months. In other words, the existence of options to extend the lease term for additional periods past the 12 month period may disqualify the lease from the short-term lease exception if it is reasonably certain that the options will be exercised.
How do you determine the impact of the lease accounting standards on any current debt covenants?
It is important to determine the impact of the lease accounting standards on your current debt covenant requirements, if applicable. With most leases recorded on the balance sheet, careful examination of the effects of increased leverage and potential debt covenant violations will be required. The severity of the impact will depend on the language embedded in each debt agreement, which should be reviewed early. You may even consider meeting with your financial institution regarding existing debt covenants.
Will I need to use judgement and estimation under the new guidance?
Yes, you will need to understand the impact of the application of judgment and estimation in the new standard. This includes applying judgment to aspects of the guidance, such as the lease term, reassessment events, and allocation of lease payments to lease and non-lease components based on the relative stand-alone selling price. Since most leases will be recognized on the balance sheet, distinguishing between a leasing component and service component of a lease becomes more critical under the new guidance. In addition, lease classification no longer has the bright line classification tests so judgment will need to be applied here and also in determining whether the customer has the right to direct the use of the identified asset.
Are there any new disclosure requirements?
The new standard significantly expands the lease disclosure requirements to provide a more comprehensive look at your leases. Under the new lease standards, disclosures will require qualitative information that may not be readily available so you should understand these disclosure requirements to ensure the information needed will be available when the time comes.
Things to Consider
In addition to these commonly asked questions, there are many other considerations such as subleases, lease accounting for lessors, sale and leaseback transactions, and business combinations that are not covered here. The bottom line is that the impact of ASC 842 to your business may be significant if you have leases. Be sure to make use of the resources available including lease accounting software, training seminars, and your trusted advisors. As always, our CPAs at Mason + Rich are ready to answer any additional questions. Feel free to call us at 603-224-2000.
First, look at the terms of the contract to ensure it meets the definition of a lease. Under ASC 842, a lease should include 1) an identified asset; 2) the right to control the use of that asset; 3) a period of time, and 4) consideration in exchange for use of the asset. After determining that a contract contains a lease, identify the separate lease and non-lease components under the contract and allocate the consideration to the various components.
How is a lease recorded under the new lease accounting standard?
While ASC 842 retains the two-model approach to classifying leases as operating or finance (formerly capital leases), the key provision is that lessees recognize all leases on the balance if the lease term is greater than 12 months. When a lessee records a lease on the balance sheet, it will recognize a right-of-use (ROU) asset with an offsetting entry to recognize a lease liability based on the present value of the future lease payments. The discount rate used will be based on the rate implicit in the lease, if readily determinable; otherwise, the lessee’s incremental borrowing rate will be used.
For expense recognition, the lessee would recognize lease expense on a straight-line basis over the lease term for an operating lease. However, for a finance lease, the lessee would recognize both interest expense (using the effective interest method) and amortization expense. As a result, the expense recognized by the lessee will be higher in the earlier life of the lease for a finance lease than for an operating lease.
What is the short-term lease exception?
A lessee may elect, as an accounting policy, not to record leases with terms of 12 months or less on the balance sheet. Instead, the lessee records the payments in the income statement on a straight-line basis over the lease term. The short-term lease exception is available only if the lease term, which includes periods covered by renewal options whose exercise is reasonably certain, is less than 12 months. In other words, the existence of options to extend the lease term for additional periods past the 12 month period may disqualify the lease from the short-term lease exception if it is reasonably certain that the options will be exercised.
How do you determine the impact of the lease accounting standards on any current debt covenants?
It is important to determine the impact of the lease accounting standards on your current debt covenant requirements, if applicable. With most leases recorded on the balance sheet, careful examination of the effects of increased leverage and potential debt covenant violations will be required. The severity of the impact will depend on the language embedded in each debt agreement, which should be reviewed early. You may even consider meeting with your financial institution regarding existing debt covenants.
Will I need to use judgement and estimation under the new guidance?
Yes, you will need to understand the impact of the application of judgment and estimation in the new standard. This includes applying judgment to aspects of the guidance, such as the lease term, reassessment events, and allocation of lease payments to lease and non-lease components based on the relative stand-alone selling price. Since most leases will be recognized on the balance sheet, distinguishing between a leasing component and service component of a lease becomes more critical under the new guidance. In addition, lease classification no longer has the bright line classification tests so judgment will need to be applied here and also in determining whether the customer has the right to direct the use of the identified asset.
Are there any new disclosure requirements?
The new standard significantly expands the lease disclosure requirements to provide a more comprehensive look at your leases. Under the new lease standards, disclosures will require qualitative information that may not be readily available so you should understand these disclosure requirements to ensure the information needed will be available when the time comes.
Things to Consider
In addition to these commonly asked questions, there are many other considerations such as subleases, lease accounting for lessors, sale and leaseback transactions, and business combinations that are not covered here. The bottom line is that the impact of ASC 842 to your business may be significant if you have leases. Be sure to make use of the resources available including lease accounting software, training seminars, and your trusted advisors. As always, our CPAs at Mason + Rich are ready to answer any additional questions. Feel free to call us at 603-224-2000.
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