After a series of deferrals, the new lease accounting standard is finally on the horizon for privately held companies and nonprofits. As its impact is significant, companies and organizations should become familiar with the new standard in advance. This blog will walk through key concepts and considerations for implementing this new lease accounting standard for lessees.
In February 2016, the FASB issued ASU No. 2016-02, Leases, which is intended to improve financial reporting about leasing transactions. The new standard will require entities that lease assets, with terms greater than 12 months, to recognize on the balance sheet the assets and liabilities for the rights and obligations created by those leases. This ASU also will require disclosures to help financial statement users better understand the amount, timing and cash flows arising from leases.
- Public companies: Fiscal years beginning after Dec.15, 2018
- Private companies and nonprofits: Fiscal years beginning after Dec.15, 2021
- Early adoption is permitted
Similar to legacy GAAP, there are two classifications for leases. Under ASC 842, these classifications include finance leases and operating leases. In determining whether a lease qualifies as a finance lease, one of the following conditions below must be met under ASC 842. Otherwise, the lease is to be classified as an operating lease.
- Lease transfers ownership of asset to the lessee at the end of the lease term
- Lease includes a bargain purchase option
- Lease term is for the major part of the remaining economic life of the asset (no longer 75-percentthresholdas per ASC 840)
- Present Value of lease payments amounts to substantially all of the fair value of the leased asset (no longer 90-percentthreshold)
- The underlying asset is of such a specific nature such that it would have alternative use to the lessor
Finance Lease Accounting
- A right-of-use asset and finance lease liability are recognized on the balance sheet based on the present value of lease payments throughout the lease term.
- The right-of-use asset is amortized over the lease term, with amortization expense being recognized as an operating expense using the straight-line method.
- The lease liability is amortized, and an interest expense is recognized accordingly. This results in higher expense in earlier years of the lease term.
- Major overhaul from legacy GAAP accounting under ASC 840.
- A right-of-use asset and lease liability are recognized on the balance sheet based on the present value of lease payments throughout the lease term.
- A single lease expense is recorded using a straight-line method.
- The lease liability is reduced by cash payments; whereas the right-of-use asset is reduced by the lease expense less an interest component.
Choosing Your Discount Rate
- If readily available, the discount rate used should coincide with the rate implicit in the lease. However, this rate is typically not readily available or impractical to obtain.
- Alternatively, ASC 842 allows to the discount rate to coincide with “the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.”
- A weighted average cost of capital can be a reasonable basis for the discount rate.
The Lease Term
- The lease term includes the non-cancellable term under the lease agreement in addition to periods covered by:
- An option to extend, if reasonably certain to do so.
- An option to terminate, if reasonably certain not to do so.
- Either of the aforementioned, if the lessor controls the ability to exercise that option.
- When evaluating reasonable certainty with respect to term options, one should consider the contractual benefits and costs within the lease (i.e. penalties, favorable pricing, etc.) along with the ability to replace the underlying asset.
Adoption and Transition
- ASC 842 was amended so that adopters may elect to not recast comparative periods on the financial statements. In doing so, adopters must:
- Apply ASC 840 (legacy GAAP) in comparative periods
- Provide ASC 840 disclosures for all periods presented in accordance with ASC 840
- Recognize the effects, if any, of applying ASC 842 as a cumulative-effect adjustment to retained earnings as of Jan.1, 2019
- Deferred rent is to be eliminated upon transition by reducing any deferred rent components(to zero) against the initial valuation of the right-of-use asset. Each period thereafter, this initial reduction to right-use-asset is amortized, using the straight-line method, with a debit to right-of-use asset and a credit to rent expense
ASC 842 expands the financial statement disclosures required for leasing arrangements. For both finance and operating leases the following disclosures must be incorporated to the notes of the financial statements, at minimum:
- Nature of leases
- Maturity analysis of lease liabilities
- Lease expense from operating activities and that from financing activities, with corresponding cash flows
- Short-term lease expense
- Weighted-average remaining lease term
- Weighted-average discount rate
Impact on Financial Metrics
The adoption of ASC 842 impacts certain financial metrics and ratios significantly. Adopters should discuss these changes with their banks and those charged with governance. A few such examples include the following:
- Debt-to-Equity Ratio Increase: Due balance sheet impact of operating leases
- EBITDA Increase: Due to classification of expense as amortization and interest for finance leases
- Operating Cash Flow Increase: Due to part of the payment on finance leases being classified as a principal payment (financing activity)
The implementation of ASC 842 may generate material changes to your financial statements, accompanied by accounting complexities and challenges. If you have any questions on how ASC 842 will impact your company or organization, or if you need assistance with implementation, please contact GHJ’s Audit and Assurance Practice.