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What is the new lease accounting standard?
The new lease accounting standard (ASC 842) is going to significantly change the way that we are accounting for our leases, specifically, our leases of property equipment that are greater than 12 months. We’ll be taking leases and bringing them onto our balance sheet using right-of-use assets and lease liabilities. New terminology will also replace the old “capital lease” and operating leases will now be brought onto the balance sheet.
When should we begin implementation for the new lease accounting standard?
Although the standards aren’t going into effect until our December 31st, 2022, financial statements, we can’t wait until we’re preparing those to implement – there’s simply too much involved in implementing the standard to wait until then.
Our clients have different levels of expertise, experience, and resources available and depending on their circumstance may choose to implement the new changes at various times. Some may choose to start now so that when they get to their January 31st, 2022, internal financial statements, they’ll already be ready to go and have implemented at that point. Other clients may pick a date to align with their June 30th, 2022, internal statements, and that’s okay too. What can’t happen is to wait until the end of 2022 before we get started.
What do our business owners and financial statement users have to do in response to the new lease accounting standard?
Business owners need to make sure they’ve allocated the resources and assigned responsibilities for standard implementation, and to the extent they want to be involved in it, will need to understand and select timelines. There are some timing decisions so it will require some level of involvement at the owner level.
The financial statement users will need to ensure they have a decent understanding of the new standard, including policy elections, and determine changes that will be necessary standard financial analysis practices. A lot of our users have certain ratios they look at to compare companies and their financial strengths. They may need to look at that standard analysis and make sure that it gets adjusted for the new standard. For a bank that has debt covenants requiring certain ratios, they would want to make sure that those agreements get modified so that they are reflective of what the accounting is going to look like when the new standard is implemented.
Will the new lease accounting standard affect business owners’ taxes?
There’s going to be no effect on the taxes. This is an accounting standard, and, in fact, the income statement is not going to change. The expense is still going to be recognized very similarly to what is being done right now.
What are some of the key provisions of ASC 842?
1. Scope – The new lease accounting standard applies to leases greater than 12 months of property, plant, and equipment. Among other things, it does not apply to intangibles or inventory.
2. Identify Leases – Before the leases were required to go on the balance sheet, there was not a real strong emphasis on looking at contracts. Now all contracts need to be reviewed to see if they contain a lease within them. For these purposes, a lease entails two things; 1) it entails the right to use a specific asset and 2) a right to control that specific asset. These are part of identifying leases.
3. Identify Lease Components – If you look at a contract for a lease, some of what you’re paying for may be leasing the asset, but some of what you’re paying may actually be for something else. For example, if you are leasing a building, you are both paying for the building and for someone to clean and maintain the building. Those are separate – the lease component and the non-lease component.
After identifying these individual components, you’ll allocate the payment between the lease component and the non-lease component. This is where you get into decisions needed from the owners; there is a practical expedient available to consider all of these payments as a lease payment and what that’s going to do is bring a bigger lease liability onto your balance sheet, which some people may not want to do, but it certainly makes it easier because you don’t have to go through this analysis of how much of each contract is for a lease component and how much is for a non-lease component.
4. Identify the Lease Term – Your lease term is going to be whatever the non-cancelable period is (that’s what we’re used to looking at), but now, we’re also going to have to look at options and decide whether to include them. What you’re looking for here is whether there’s an economic incentive for our clients to stay in that building.
Example: Let’s say we have a client that entered into a five-year lease with two five-year options. When they enter into the lease, they know the first thing they’re going to do is make a significant investment in leasehold improvements. If it’s only going to be a five-year lease, chances are that they wouldn’t make that big investment in the leasehold improvement and so there’s economic incentive for them to stay for that second five-year period or maybe that third five-year period. So maybe the least term in that case is a 15-year lease term, even though each lease term is only 5 years. That’s the way that this will work, so this is all going to be new and will require a reassessment. Let’s say we had that same five-year lease, but we didn’t have that leasehold improvement and we got the two five-year options. Maybe in the fourth year we decide to stay in the building and to make a significant investment in these leasehold improvements at that point. When you make that decision to make those leasehold improvements, you know that perhaps at that point, the lease term will get extended.
5. Determining Lease Payments – Your lease payments are your fixed lease payments and then your variable payments that are based on an index or a rate (based on the rate at lease commencement). So, you’ll see leases where maybe it’s a thousand dollars a month, plus any increase in the consumer price index – those kind of things are part of your lease payment.
What are not lease payments? If you didn’t take that practical experience expedient and you separated your lease components from your non-lease components, whatever you allocated to that non-lease component is not going to be a lease payment and will not get capitalized. Variable payments are not included in those payments – items like real estate taxes and common area maintenance (CAM) charges. So, if you have a lease where you’re leasing the building, plus whatever the actual common area maintenance expenses are, those additional variable pieces are not variable based on an index or a rate, they’re variable based on something else (and it could be just about anything). Generally, we see in the common area maintenance where the actual charges get charged back to the lessee. In those cases, those common area maintenance charges are not these payments. It’s just the piece that’s for the lease of the building that’s what will get capitalized and brought onto the balance sheet.
6. Determine Discount Rate – When you’re bringing the present value onto your balance sheet, part of that equation is your discount rate. We will determine a discount rate very similar to the current standards. It’s generally going to be to use the incremental barring rate, and it’s clarified now that it’s a collateralized borrowing rate and you can use the asset that you’re purchasing. So if you are leasing a truck, when you determine what discount rate you’re going to use, you have to say, “okay, if I entered into a debt agreement to borrow or buy this truck, it was collateralized by that truck, what would my interest rate be?”
There is a practical expedient available for privately-held companies where they can use a risk-free rate and that’s going to be the lowest interest rate and result in the largest hit on your balance sheet.
7. Accounting – After determining the discount rate, you have the last part you need to calculate what will be brought onto the balance sheet. You’re going to debit a right-of-use asset and credit a lease liability. The main difference between a finance lease and an operating lease is that, on a finance lease the interest portion and capitalized asset portion are treated separately. The asset will be amortized straight line, and interest expense will be accounted for like we currently do with capital leases. This results in a larger expense being recorded in earlier periods because the interest expense will be larger in earlier periods where the lease liability is higher. For an operating lease, you’re actually going to combine the interest component and the lease payment. And that combined amount will be amortized in total, resulting in overall expense being recognized on a straight-line basis over your lease term.
What is the transition for the year-end financial statement going to look like?
This will be effective for calendar years beginning with the December 31st, 2022 financial statements. There are elections available that allow for flexibility as to what the transition year looks like, especially as it relates to comparative periods. I think most of our clients are going to elect to make it effective January 1st, 2022, and not restate the 2021 comparative statements. So that means that when we present a two-year comparative statement, we show the 2022 balance sheet with the right-of-use asset and lease liability listed, and a 2021 balance sheet that does not. That is what it’s going to look like on the balance sheet, with some additional disclosures.
When you set up the initial lease liability and the initial right-of-use asset, it’s going to be for the remaining lease term as of the date that you adopted. So, on January 1st, 2022, whatever the remaining lease term is for those assets forward-looking as of January 1st 2022. Whatever the lease term and least payments are capitalized at your discount rate, is going to come on to your balance sheet January 1st, 2022.
An alternative is, if you want your balance sheet to be more comparative, to make the standard effective January 1st, 2021. Then re-do the accounting for 2021 following the new standard. So, you look at your leases and remaining lease terms and payments as of January 1, 2021 and capitalize them to bring them on to your balance sheet as of January 1st 2021. I don’t think too many people are going to want to do that – it’s certainly going to be excess work to do it that way.
If you’d like a more tailored view of how this standard affects your business, contact us to speak with an advisor.