Recently the Financial Accounting Standards Board (FASB) introduced significant changes in the accounting requirements for leases. These new requirements have been codified under the Accounting Standards Codification (ASC) 842. ASC 842 is already effective for public companies. Private companies and certain not for profits must adopt ASC 842 in fiscal years beginning after Dec. 15, 2021. Therefore, a calendar year entity must adopt the change in 2022.

The new standard applies to private companies and not-for-profit organizations that report their financial results in accordance with Accounting Principles Generally Accepted in the United States (GAAP). Although lessors will be required to make some changes on how they report leases on financial statements, the more significant impact will be for lessees.

According to ASC 842, the new rules are primarily designed to “increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing transactions.”

To comply with the new standard’s requirements, an entity must also record assets and liabilities relating to operating leases on the balance sheet and add various new disclosures in the financial statements notes.

With the new standard, all leases must appear on the balance sheet as a right-of-use (ROU) asset and lease liability. These terms are described in Paragraph 3 below.

The new lease standard is intended to account for all lease obligations on the financial statements, rather than excluding operating leases, as has been the previous practice. This change ensures that a company’s financial situation is reflected as accurately as possible within the financial statements. ASC 842 requires lessees to record all leases with terms greater than 12 months on their balance sheets. Anything shorter than that is defined as a short-term lease, which lessees can choose not to record on their balance sheet. They can instead just recognize a lease expense on a straight-line basis. However, ASC 842 states that if the lease agreement includes a lease renewal option that the lessee is reasonably certain to exercise, then the lease term should account for such option. This may result in many leases, which otherwise would be deemed short-term, to be brought into the territory of required presentation as ROU assets and lease liability on the balance sheet.

Significant judgements or assumptions are required for determining whether a contract contains a lease (embedded leases), determining standalone prices for lease and nonlease components and determining the discount rate for the entity’s leases. If foreign currencies are involved, specific attention is required for conversion factors. Entity’s management is required to take these matters into consideration during the application process of ASC 842.

In contrast to ASC 840, the previous lease standard, which considered the agreement date to be the measurement date, ASC 842 considers the lease commencement date to be the measurement date.

In addition, ASC 360 provisions relative to Impairment and Abandonment continue to apply, as do termination penalties.

The standard also requires a reassessment of the lease computations and disclosures when there is a Triggering Event, i.e., when a contract requires a lessee to exercise or not to exercise an option. The significance of the event usually determines if reassessment is appropriate.

ASC 842 will have an impact on most financial statements. For example, the majority of businesses lease office space. Under ASC 842, these leases will now be recognized on the balance sheet as an asset and a liability. This change may also have an impact beyond the financial statements, for example, on bank covenants effected by this new liability. Therefore, we recommend that you start the implementation process as soon as possible to fully address the change to the financial statements and any potential issues.

1. The Difference Between Operating and Finance Leases

It is worth noting that ASC 842 has preserved the distinction between operating leases, and finance leases (formerly capital leases). A lease is a finance lease if any of the following five criteria apply:

a. The ownership of the underlying asset will be transferred to the lessee at the end of the lease contract.
b. The lessee has the option to purchase the underlying asset.
c. The lease contract is for a major part of the useful life of the asset.
d. The lease payments’ present value and any guaranteed residual value is substantially equal to or greater than the fair market value of the asset.
e. The underlying asset is specialized to the use of the lessee only.

If none of the above apply, then the lease is an operating lease.

While both types of leases are now recorded on the balance sheet, there are differences in the accounting process for each.

Under the previous standard ASC 840, lessees could not record a finance (capital) lease asset that was greater than the fair value of the asset. ASC 842 requires the asset be recorded at the amount calculated using the appropriate discount rate, even if this amount is greater than the fair value of the asset.

2. Right-of-Use and Lease Liability

Lessees are now required to record a right-of-use (ROU) asset, which represents their right to use the leased asset for a period, along with a corresponding lease liability equal to the present value of the lease payments. The ROU asset is equal to the lease liability plus any initial direct costs and prepaid lease payments and minus any lease incentives. The lease liability is measured by taking the present value of all remaining lease payments and applying the discount rate. The discount rate is the Implicit Rate in the lease terms; if this rate is not readily determinable, the Incremental Borrowing Rate should be used.

3. Additional Disclosures

ASC 842 requires several more qualitative disclosures than its predecessor ASC 840. These include:

a. Future leases not yet in effect.
b. Whether the lessee accounts for short-term leases by not recognizing a right of use asset and lease liability.
c. Gains and losses associated with lease transactions.
d. Discount rates and remaining terms based on weighted average calculations.

For lessors, the new or expanded disclosures will also be required to include:

i. Income from leases.
ii. Investment in leases.
iii. Judgments or assumptions affecting leases.
iv. Information on related-party transactions involving leases.
v. Assessments of payments and receivables relating to leases.
vi. Risk management details.

4. Service Contract and Operating Lease

Lessee’s must evaluate and determine whether an arrangement is a service agreement, a lease, or both, as service agreements are not accounted for under ASC 842.

While the complexities of determining whether a contract is for service or is a lease requires an examination of each contract’s specific terms, suffice it to say that in many cases the lease element may by embedded in a service contract and may require isolation and separate accounting treatment.

The Examples given by ASC 842 of situations where contracts contain lease and nonlease components are enclosed in Annexure I for your convenience. A review of these examples indicates that all contracts which contain these two components require detailed evaluation to ascertain the lease and nonlease segments; these separable parts of the contract then require accounting treatment appropriate for leasing and non leasing transactions.

Please note that the FASB provides a practical expedient which allows a lessor to account for the combined component as a single performance obligation in accordance with ASC Topic 606 , when the nonlease component(s) associated with the lease component is the predominant component of the combined component. Otherwise, the lessor would account for the combined component as an operating lease in accordance with ASC Topic 842.

In our view, the use of the word “predominant” should not only be evaluated from the relative significance of the two components in individual contracts but also with respect to the overall materiality of the amounts of each component, particularly where a large number of similar contracts are involved and the aggregate amounts of these component is significant to the financial statements.

Please also note that the proper classification of the contract may also have tax consequences for both the lessor and the lessee.

5. Transition Options

ASC 842 allows an entity to apply the new standard using one of the following two methods:

a. Comparative – Retrospectively to each prior reporting period presented in the financial statements with the cumulative effect recognized at the beginning of the earliest comparative period presented. Under this transition method the application date shall be later of the beginning of the earliest period presented on the financial statements or the commencement date of the lease.

b. Effective – Retrospectively at the beginning of the period of adoption through a cumulative-effect adjustment.

The regulations have allowed certain practical expedients for the initial application of the new standard. An entity may elect the following Practical Expedients as a package that must be applied to all leases (lessee or lessor):

i) An entity need not reassess whether any expired or existing contracts are or contain leases.

ii) An entity need not reassess the lease classification for any expired or existing leases (that is, all existing leases that were classified as operating leases in accordance with Topic 840 will be classified as operating leases, and all existing leases that were classified as capital leases in accordance with Topic 840 will be classified as finance leases).

iii) An entity need not reassess initial direct costs for any existing leases.

Please note that for the operating leases the ROU should be expensed consistent with similar assets and disclosed in the income statement or related notes. For the cash flow presentation of operating leases, the entire cost should be classified as lease expense in operating activities. This is different from a finance lease under which principal payments should be reflected as financing activities, and both amortization and interest payments should be reflected in operating activities in accordance with Topic 230.

Please let us know if you have any questions or concerns regarding the above matters. The rules are complex and the accounting on the books and records demanding. We are here to help. Contact us to set up an appointment.

 

 

 

L.H. Frishkoff & Company

546 Fifth Ave. New York, NY 10036
212-808-0070

565 Taxter Road, Elmsford, NY 10523
914-523-2047

L.H. Frishkoff & Company

546 Fifth Ave. New York, NY 10036
212-808-0070

565 Taxter Road, Elmsford, NY 10523
914-523-2047