Co-authored by: Gretchen Leifeste
- ASC 842, the new lease accounting standard, becomes effective for private companies in 2022.
- FASB made a number of practical expedients available, but companies need to carefully consider whether or not to elect these expedients based on their reporting requirements, types of leases, and other accounting policy elections.
- Adopting ASC 842 can be a complex and time-consuming project for a variety of reasons, so start the process now.
With just months to go before many private companies are required to bring leases onto their balance sheets, a recent poll of executives found that 19.8% of companies feel unprepared to comply with Accounting Standards Update No. 2016-02, Leases (Topic 842).
The new lease accounting standard becomes effective for private companies for periods beginning after December 15, 2021 (calendar 2022). It brings all leases onto private company balance sheets by creating right of use (ROU) assets and liabilities. In essence, operating leases will now be on the balance sheet, capital leases become finance leases, and the concept of deferred rent is eliminated.
As public companies learned when they adopted the new rules in 2019, calculating ROU assets and liabilities can be complex, and companies need to exercise care and judgment when evaluating lease agreements during implementation.
Topic 842: Practical Expedients
Fortunately, the Financial Accounting Standards Board (FASB) made a variety of practical expedients available to private companies.
The first three practical expedients constitute a package that must be elected together. This package includes the option to:
1. Not reassess whether a contract is or contains a lease
If accounting for embedded leases in service and outsourcing contracts were appropriately considered under ASC 840, you would not need to reevaluate those contracts. However, errors in previous evaluations would be considered errors under ASC 842.
2. Not reassess the lease classification and simply maintain the original classification
This means if all prior leases were classified as operating leases in accordance with ASC 840, they would be classified as operating leases. All existing leases classified as capital leases will be classified as finance leases. Again, errors in classification under ASC 840 will also be considered errors under ASC 842.
3. Not reassess initial direct costs
Initial direct costs are costs that were previously capitalized and could have been avoided had the entity not entered into a lease agreement. Entities can elect not to reassess previously capitalized indirect costs.
Other practical expedients can be elected on an à la carte basis:
- Lessees may use hindsight in determining the lease term and assessing the impairment of the entity’s ROU assets.
- Lessees may elect not to assess whether existing or expired land easements that were not previously accounted for as leases are or contain a lease.
- Private companies can use a risk-free rate as the discount rate for all leases instead of an incremental borrowing rate.
These optional expedients can make it easier for lessees to transition from legacy lease accounting guidance. However, deciding to elect or not elect these practical expedients will vary depending on the organization’s reporting requirements, types of leases, and other accounting policy elections.
5 Steps to Take Now for Lease Accounting Readiness
Companies should consider the following five steps for efficient and timely implementation of Topic 842:
1. Collaborate With Other Departments
Your accounting and finance teams should collaborate closely with operations and others involved in the leasing process to ensure that the set of leases to be considered in implementation is complete and accurate. Many public companies found that this step alone took a month or more to complete, so don’t put it off until year-end.
Any new leases or modifications to existing leases will need to be communicated to the accounting department in real-time going forward. Estimating the expected lease term should be made in consultation with the business as a whole.
2. Remain Alert to Contracts That Are or Contain Leases
Each contract entered into by the organization needs diligent analysis to determine whether it contains or includes a lease. Contracts that include outsourcing services, data centers, hosting, or other IT arrangements are common examples of embedded leases.
Some of these arrangements may not have constituted a lease under the previous standard but are now in-scope under Topic 842. Therefore, it’s crucial to review all service agreements to confirm that they do not include embedded leases.
3. Don’t Reinvent the Wheel
Leverage the experience and knowledge of professionals and service providers who are already familiar with Topic 842 and can proactively identify common pitfalls to implementation.
If you have a large portfolio of leases, consider investing in lease management software. Many off-the-shelf and purpose-built solutions, including LeaseCrunch, can standardize and aggregate the organization’s lease information.
This software can also automate the calculation of ROU assets and liabilities, create recurring journal entries, create disclosure schedules, and maintain an audit trail useful to both internal and external users.
4. Discuss Impacts With Management
Discuss the anticipated impacts of adopting Topic 842 with management to ensure that they are prepared to understand how financial results will be affected.
With ROU assets being classified as noncurrent and the lease obligation being broken out between current and noncurrent liabilities, your organization’s current ratio, debt-to-net-worth ratio, and debt-service coverage ratio can be impacted dramatically.
Review debt agreements to determine if covenant compliance will be affected by bringing leases onto the balance sheet. If they are, you need to discuss options with your lender proactively.
5. Document Significant Aspects of Implementation
Finally, ensure you thoroughly document all significant aspects of implementing Topic 842. For example, your organization’s accounting policies should document any practical expedients elected, judgments and assumptions used when creating estimates, including consideration of materiality and internal controls related to leases.
Policies should also be forward-looking and align implementation decisions for existing leases with the treatment of new leases.
Start Preparing for Topic 842 Today
Regardless of whether your company has one lease or hundreds, successfully adopting the new lease standard can be a complex and time-consuming project. Many public companies that adopted Topic 842 found that the adoption process took much longer than expected for a variety of reasons. Start the process now. If you need help, get in touch with our Advisory team today.