Managing financial reporting and accounting requirements can be challenging – especially when you must also prepare for changes in accounting standards, such as the lease accounting standard in effect for private companies beginning in January 2022.
More heavy lifting than you might expect
Not only does the new lease standard make fundamental changes to the definition of a lease, but it’s also a time-consuming process for many. Updating processes, reviewing internal controls, and changing financial reporting mechanisms is already a daunting task, and that’s before taking into account the often surprisingly heavy burden of assembling and reviewing all your leases (many are finding that under the new standard, they have many more leases on the books than expected). On top of all that, a Lease Accelerator survey of private companies found 75% of respondents say that implementing the new lease standard is more or as complex as implementing the revenue recognition standard.
What you need to know
To help you prepare for adopting the new lease standard and create a solid foundation, here’s an overview of what the new lease accounting standard is, key provisions, and smart tactics to help you achieve an optimal outcome.
What are the new lease accounting rules?
The new lease accounting standard (ASC 842) requires companies to put all lease contracts on the balance sheet – not just capital leases. Under earlier guidance, operating leases were typically only disclosed in the notes of financial statements. Moving forward, entities will record a right-of-use asset and a lease liability on their financial statements for operating leases, in addition to accounting for finance leases (known as capital leases prior to ASC 842).
What’s a lease?
A contract is a lease under ASC 842 if the lessee controls substantial economic benefits from using the asset and can direct its use. The lease contract begins on the date the asset becomes available for use. Entities determine whether each lease should be classified as an operating or a finance lease at the commencement date of the lease.
A lease should be classified as a finance lease by the lessee if the lease meets any of the following criteria:
- The lease transfers ownership of the underlying asset to the lessee on or before the end of the lease term.
- The lease gives the lessee an option to purchase the asset and the lessee is reasonably certain to exercise that option.
- The lease term represents the major part of the remaining economic life of the underlying asset. (However, if the underlying asset is at or near the end of its economic life as of the beginning of the lease, this criterion is not applicable.)
- The present value of the sum of the lease payments, and any residual value guaranteed by the lessee not already included in lease payments equals or exceeds substantially, all of the fair value of the underlying asset.
- The underlying asset is so specialized for a particular purpose that it is not expected to have an alternative use to the lessor when the lease is over.
A lease should be classified as an operating lease if none of the criteria above are met.
A lessee may elect an accounting policy to not recognize an asset and lease liability for a short-term lease. A short-term lease is one with a term of 12 months or less as of the commencement date, and does not have a purchase option that the lessee is reasonably certain to exercise.
An important first step
It’s important for companies to first identify a complete list of their leases. Often, entities will find that they have more leases than they initially identify. Companies will need to review vendor contracts to determine whether they contain embedded leases and examine each according to the new definition of a lease.
Lessons learned from public companies
Since public entities have already implemented these changes, they provide a useful map of what to expect – and what to watch out for.
Long-term benefits for private entities include more centralized lease management and the potential for improved cost management.
The implementation is not without its challenges. First, it’s more complicated than what many CFOs may think initially. Leases and lease contracts are often located in different departments, which can make it hard to simply track down where every lease is recorded – to say nothing of how it’s accounted for. Enlisting the help of other departments, especially operations and legal staff, can be useful.
Having other departments help sort through lease contracts is also helpful when it comes to gathering all related documentation. It’s quite possible that locating all the information needed for how the lease is accounted for will not be in the lease contract itself. Prepare to do some digging.
That same lack of consistency in where leases are recorded makes applying a uniform accounting approach to every existing lease challenging as well. ASC 842 seeks to simplify lease accounting, but first private entities need to evaluate each lease on its own according to the new framework.
Locating embedded leases has proven to be especially challenging, and private entities should expect much of the same. For example, right-of-use provisions contained in some service contracts meet the definitions of a lease.
Help is here
Public companies with several leases have found it necessary to switch from a manual, Excel-based documentation model to an automated lease accounting software. Barnes Dennig has partnered with LeaseCrunch, which calculates the journal entries for the right-of-use assets, lease liabilities, and many of the new disclosures required under ASC 842.
Compliance with the new lease accounting standard will be a complex task for many businesses, and many are finding they need outside help to implement the standard effectively and completely. If you have questions about lease accounting or need assistance with your implementation, Barnes Dennig is here to help. Contact us for a free consultation with a member of our lease accounting team.