It’s the Lease We Could Do
If it feels like we’ve been discussing the impacts of the new lease standard for a long time, it’s because we have. In February 2016, the Financial Accounting Standards Board issued Accounting Standards Update (ASU) 2016-02. The implementation date of the standard has been delayed multiple times, but nearly 7 years later, it is finally time to apply the impacts of everybody’s favorite ASU: Accounting Standards Codification 842, Leases.
Private companies will be required to implement the standard for years beginning after December 15, 2021, i.e. calendar years ending December 31, 2022. The implementation will require lessees and lessors to recognize and measure leases as of the adoption date, or January 1, 2022.
Remember, this is only for reporting under Generally Accepted Accounting Principles (GAAP), and does not affect reporting for income tax purposes. If your company is required to follow GAAP, please keep reading.
So, what does ASC 842 require? Here’s a brief overview:
From a lessee perspective, all leases will be recorded on the balance sheet, with the exception of short-term leases. At lease commencement, a lessee will classify a lease as either a financing lease or an operating lease. A lease is considered a financing lease when it meets any of the following criteria:
- The lease transfers ownership of the leased asset to the lessee at the end of the lease term
- The lease grants the lessee an option to purchase the underlying asset, and the lessee is reasonably certain to exercise the option. (Note: this does not have to be a bargain purchase option)
- The lease term is for a major part of the remaining economic life of the asset
- The present value of the minimum lease payments equals or exceeds the fair value of the asset
- The asset is not expected to have any value or alternative use to the lessor at the end of the term
Sounds like the definition of a capital lease in the previous standard, right? If none of this criterion is met, the lease is determined to be an operating lease. However, under the new standard, both types of leases will be recorded on the balance sheet.
In addition, both types of leases will initially be measured the same. A lease liability will be credited by using a discount rate on the future lease payments, and a “right-of-use” asset will be debited. Subsequent measurement between the two types of leases differs slightly as financing leases will require the recognition of an interest component, while operating leases will not. Overall, the expenses and cash flows from a leasing transaction have not significantly changed from the previous guidance. The primary difference is the recognition of lease assets and liabilities on the balance sheet for operating leases when these were previously off-balance sheet transactions.
From a lessor perspective, the accounting is largely unchanged. Lessors will classify leases as sales-type, direct financing, or operating. Sales-type and direct-financing leases will require the de-recognition of the underlying asset and a net investment in the lease, similar to current guidance.
Seems straightforward. Using present value models and discounted cash flows is not a new concept. Implementation should be a breeze.
A few other items to consider that may impact the recognition and measurement of right-of-use assets and lease liabilities.
Lease terms: lease terms may include renewal options. Do you include the time period for the renewal options in the initial calculations? The answerdepends on if you are reasonably certain to exercise the option. What does reasonably certain mean? Well, that’s up to you to decide if you’ll take that renewal option that might be 10 years from now.
Lease payments: Leases may include variable payments, payments that escalate over the lease term, or may have purchase and termination options.
Discount rates: What discount rate is appropriate? The guidance would indicate the rate implicit in the lease, but this isn’t easily determined very often. Additional clarification by the FASB suggests the lessees incremental borrowing rate or the risk-free discount rate (for non-public entities) may be used.
Logistically, implementation may be difficult in even identifying and accumulating all of the lease information for your company. This documentation is not always centralized and could exist in multiple places. There’s also the need to identify embedded leases within contracts and separating lease and non-lease components, among other intricacies.
After everything is implemented, we’ll also have to consider the effect on the financial statements. The standard will have an impact on debt-to-equity ratios, debt service coverage ratios and EBITDA calculations. It will certainly make a difference in decisions to lease or buy equipment, vehicles, or office space. It’s important to talk to your lenders sooner rather than later to make sure they are aware of the changes that will be coming in your 2022 financial statements. For many clients, this may be more trouble than it’s worth and lenders might remove the effects of the standard for their analyses anyway. The option of a reporting exception in your GAAP basis financial statements might be worth exploring.
While the concept in its simplest form is rather straightforward, the FASB hasn’t disappointed in including complexities that will make implementation a task. Your KT auditor and advisor will be reaching out soon if they haven’t already. If you have any questions, please contact a member of our lease implementation team. Our lease implementation team members include: Jean Smith, Jeff Yennie, Austin Eichacker, and Kyle Kopren.