Change is on the horizon. Following passage, delays, and a whole lot of posturing about the nuances, the lease standard, ASC 842, is starting to come into existence. For public companies, the transition company was complex and costly. Private companies may face the same issues, but they do have one thing on their side—time.
Announced in June 2020, ASU 2020-05, Revenue from Contracts with Customers (Topic 606) and Leases (Topic 842): Effective Dates for Certain Entities gave private companies a bit more time to adjust their practices. But with the clock ticking down on the time to adopt the new standard, it’s crunch time.
As with ASC 606, a standard considered much more impactful and complex, public companies needed to implement the standard a year before private ones. For finance leaders at private companies, you get a few benefits. First, you get to see the pitfalls that others faced on the way to implementing the standard. Second, we’re excited to share a new ASC 842 Handbook.
ASC 842 Lease Accounting Standard Handbook for Private Companies is a new guide from LeaseAccelerator written to help private company leaders to understand the complexities and best practices for putting this plan into action. Offering a variety of insights on the path to ASC 842 adoption, you’ll learn a lot about the path to making this as low-stress as possible. Below, you can learn about just some of the things you need to know:
Seven Changes in the New Lease Standard
For US lessees, adoption of the rules creates a significant change from ASC 840 reporting where operating leases are off-balance sheet. But what are some of the biggest changes and how can you prepare yourself? Here are seven.
1) Leases Capitalized:
The rules require a lessee to capitalize all leases longer than 12 months. While leased assets are capitalized normally, lease obligations should be recorded using the lease term and lease payments based on assumptions related to contractual rents, including:
- Bargain or compelling renewal rent and purchase options where the lessee is reasonably certain to exercise the options
- Variable (contingent) rents
- Likely payments under residual guarantees
2) Estimates of Lease Term and Lease Payments:
For purchase and renewal options, a lessee should reassess whether the exercise of an option is “reasonably certain” Key changes for the latest standard (and thus must be recognized) only upon the occurrence of a significant event or a significant change in circumstances that is within the lessee’s control.
Existing capital leases are grandfathered under ASC 842. For the FASB, lessees may choose between two available transition methods. The first is a “modified retrospective” approach where all operating leases existing at or entered into after the date of initial application are booked on a prospective basis, but those that expire in the periods of comparative statement will not have to be rebooked.
The asset and obligation are booked at the PV of remaining rents at the earliest date presented in the financial statements. The second transition option is a practical expedient that was approved in 2018 which allows private companies to “recognize a cumulative effect adjustment to the opening balance of retained earnings” at their adoption date. Both transition methods must be applied in the same way.
4) Present Value Calculation:
The lessee calculates the PV of the estimated lease payments using the implicit rate in the lease, if it is known to the lessee, or the company’s incremental borrowing rate (the interest rate the lessee would incur to borrow under a secured loan with terms similar to those of the lease).
This implicit rate is defined as follows:
“The rate of interest that, at a given date, causes the aggregate present value of (a) the lease payments and (b) the amount that the lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (1) the fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor and (2) the deferred initial direct costs of the lessor.”
5) The Profit & Loss statement:
For finance leases, the asset is amortized as an expense in the P&L over the estimated lease term on a straight-line basis (SL) Interest expense is imputed on the lease liability. The sum of the interest and amortization creates a front-loaded lease expense pattern.
Capitalized operating leases continue to use the straight-line average rent as the expense, and operating lease assets and liabilities are reported separately from capital lease assets and liabilities .
6) Lease Payment Breakdown:
Under the standard, the lease payment for a finance lease is broken down into: (1) an interest component (charged to P&L), and (2) a principal component.
7) Lease Cost for Operating Leases:
The reported lease cost for those leases that qualify as operating leases is the same as it is under current GAAP, that is, the straight-line average of the lease payments reported as rent expense The “rent expense” is the sum of the imputed interest on the liability and amortization of the asset.
Learn More: Full Guide Highlights All the Key Paths to Transition Success
Getting your accounting process for leases in order can go a long way in reducing risk. The ASC 842 Lease Accounting Standard Handbook for Private Companies shares a variety of tips for leaders looking to get everything tied up before the effective date. This guide includes the following and more: How to get your organization started now
- What the new FASB ASC 842 rules entail
- The SEC reporting imports
- Which data and documents you’ll need to collect
- Required lease accounting software changes
- Real world accounting examples