The New Lease Accounting Standard: What You Need to Know
The new lease accounting standard is a hot topic but not an entirely unfamiliar one. By now, you probably know that the new lease standard (ASC 842) is effective in 2022 for calendar year-end private companies. Under the new standard, companies are now required to recognize operating leases on the balance statement as an asset and a lease liability.
While many businesses aren’t required to comply with this change until issuing their annual financial statements at the end of 2022, it’s important to start addressing the transition proactively. In fact, being proactive can really pay off.
Financial Statement Highlights: Avoid Surprises
There are some changes to the financial statements it’s important to know – first, as of January 1, 2022, a material journal entry will be made affecting assets and liabilities for substantially all private companies as nearly all companies enter into operating leases. Early adopters, either public or private entities, have found there was often a larger liability recognized on the balance sheet than originally anticipated.
According to a recent LeaseQuery survey, 58% of early adopters found operating leases embedded in other contracts that needed to be recognized on the balance sheet, and 75% indicated that implementation of the new lease standard was as complicated or more complicated than adopting the recently effective revenue recognition accounting standard. Those are the types of issues you’ll want to manage sooner rather than later to avoid unpleasant surprises – and an unanticipated hit to your bottom line.
Top Unexpected Implementation Challenges – and Where to Start
The biggest challenge for many is just getting started. Once implementation starts, the complexities of the process quickly become apparent. The first step is to get a handle on all vendor contracts and examine them for provisions to control a piece of identified property. This is a technical determination to see whether a lease exists. The examination needs to go beyond a document that simply says ‘lease’ at the top.
Concurrently, it’s necessary to read each document in its entirety to see whether it meets the technical requirements to be presented as a lease. In many cases, what was historically identified as a lease and disclosed on the financial statement was insufficient to comply with the definition of a lease under the new accounting standard.
While the complexity of the new lease standard starts with being proactive, there’s a strategic element to the process as well. For years, public and private companies have structured leases to get a desired impact, whether they wanted it on the balance sheet or off the balance sheet as an operating lease. Even now, there are opportunities to structure or renegotiate a lease to position for a more favorable impact, either to avoid the recognition of the lease liability or to reduce the amount recognized.
The contract management approach to avoid recognizing operating leases on the balance sheet really centers on the definition of a lease and whether what is signed in a contract is or contains a lease by transferring control of plant property and equipment.
Determining if control has been transferred, or what changes to the contract would be necessary to change that determination is going to be a more sophisticated process in many respects because the straight mathematical calculation used to categorize leases between capital and operating leases will not be there.
For example, if companies can achieve the same commercial objective by perhaps contracting for an output, as opposed to contracting for control of an identified piece of property, plant, or equipment, they may find a more desirable accounting result.
Here’s another example – in the new lease standard, there are two cases. In one, an entity contracts for use of servers, and those servers are leases. In the other case, the entity instead contracts for a certain amount of network services at a desired speed, and it’s up to the vendor to meet the desired output. In that case, it’s not a lease.
This highlights how similar arrangements can have different accounting treatments based on the specific terms; providing the opportunity to manage the desired accounting outcome if done proactively.
The Time to Start Is Now
Attempting to achieve a particular financial reporting outcome like that can’t be done until you gather all contracts, centralize management, and read each to identify potential negotiation opportunities.
And, any new future contracts should be reviewed prior to execution to identify the accounting impact and to identify opportunities to adjust the agreement to get a different financial reporting outcome.
It’s critical not to underestimate the complexity of the new lease standard and the opportunities available to those who are proactive. Once leases are signed, the accounting treatment is dictated. To achieve the results you want, it’s important to understand the standard, get ahead of the process, and negotiate leases in advance to get a more favorable position.
While it may be tempting not to take action on lease accounting compliance until later in the year, it’s important to start the lease review process early. This provides maximum flexibility in managing the changes to the company’s financial statement.
If you have questions about the information outlined above or need assistance with an accounting or tax issue, contact us to connect with one of our top lease accounting pros – we’re here to help.