The long-awaited deadline to implement the new lease accounting standard is upon us. Beginning in 2022, your business will be required to report almost all leases on the balance sheet.
Is your business ready?
ASC 842, Leases
In 2016, the Financial Accounting Standards Board (FASB) issued a new lease accounting standard that would significantly change how businesses report leases on their financial statements. After multiple deferrals, Accounting Standards Codification (ASC) 842 will soon require companies that report under US GAAP to record most of their leases on their balance sheet. Under current GAAP guidance, many leases can remain off the balance sheet, with the effects of lease payments impacting only the income statement.
This change is anything but simple. It will require you to track and categorize all your leases, collect quantitative and qualitative information about those leases, and report that information on your balance sheet, income statement, and disclosures to the financial statements. If you haven’t already formulated a plan to adopt this new standard, it’s time to get the ball rolling.
Types of Leases Under the New Standard
The new lease accounting standard asks you to categorize each of your leases as one of the following:
Finance leases are long-term leases of assets where any of the following are true:
- The title of the asset transfers to you at the end of the lease term;
- The lease has a purchase option that you reasonably expect to exercise;
- The lease term spans the majority (or entirety) of the asset’s economic life;
- The present value of the lease payments exceeds all the fair value of the asset; or,
- The asset is so specialized that the lessor could not lease it to anybody else.
These types of leases are known as capital leases under current GAAP guidance, and in general, accounting for them won’t change. When you enter into a finance lease, it should be reported on your balance sheet as a leased asset with a corresponding lease liability.
As you make payments, you’ll (1) reduce your lease liability and record interest expense and (2) record depreciation expense to offset the book value of your leased asset.
Operating leases are also long-term leases of assets. The main difference is that these assets will be traded out before the end of their useful lives. Common operating leases are assets that need to be upgraded frequently, like computers, aircraft, vehicles, and machinery, as well as real estate-related leases such as an office or warehouse space.
Under current GAAP guidance, operating leases are only recorded on the income statement; when you make (or accrue) a monthly payment, you record a lease expense. But this changes under ASC 842. New accounting guidance requires you to treat operating leases similar to finance leases on the balance sheet. They will be recorded on the balance sheet as a “right-of-use asset” with a corresponding liability that represents the present value of the remaining lease payments.
As you make payments, you’ll record lease expenses on a straight-line basis (similar to the treatment of operating leases under existing standards) along with reductions to both the right-of-use asset and the lease liability. At the end of your lease term, both the right-of-use asset and its corresponding liability are reduced to zero.
Short-term leases are less than 12 months in duration and do not have an automatic renewal at the end of the lease term. By default, short-term leases are treated the same as operating leases, but you can elect to keep short-term leases off the balance sheet if you wish. If you make this election, you will simply expense your lease payments over the lease term.
The FASB released ASC 842 back in 2016. Public companies were expected to comply with the new standard for periods that began after December 15, 2018 – i.e., on reports for the calendar year 2019 – but private companies were given a few additional years to comply. Private companies must now implement the new lease reporting standards on their annual financial statements for fiscal years that begin after December 15, 2021, and on their interim reports for fiscal years that begin after December 15, 2022.
Things You Should Do Before 2022
The deadline for implementing this new standard is approaching. You’ll need to start tracking your leases on January 1st of next year. Here are a few things you should do before the deadline is here.
- Categorize your leases.
Analyze your lease agreements to see what types of leases you’ll have, and place each lease (or group of leases) into one of the above three categories.
- Decide how you’ll treat short-term leases.
If you wish to keep your short-term leases off the balance sheet, build that standard into your written policies.
- Talk to your bank.
Adding right-of-use assets to your balance sheet will artificially boost your asset and liability balances which could cause you to be in violation of your debt covenants. Talk to your lenders about this problem now to determine your best path forward.
- Consider implementing lease tracking software.
Tracking right-of-use assets can be cumbersome. If you have many leases, it may be helpful for you to invest in software that can track the amortization schedule for each lease (or group of leases).
And lastly, contact MST if you have questions or concerns about your lease activity. We have already assisted some clients with the transition, so we know what to expect. We know what pitfalls to avoid, and we know what tips will help your company make the transition go as smoothly as possible. We hope to hear from you soon.