What to Know About the New Lease Accounting Standard

The effective date for private companies to comply with Accounting Standards Codification 842 is on the horizon. The new standard clarifies definitions and businesses will need to make sure they’re familiar with the terms.

Thursday, November 11, 2021 – Every day that passes marks less time for private companies to get ready for ASC 842, the new lease accounting standard. Private companies will have to comply with this standard in fiscal years beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022.

ASC 842 is intended 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.” Because ASC 842 applies to most leases and subleases, with limited exceptions (e.g., leases of intangible property; leases of minerals and biological assets, including timber; leases of inventory; and leases of assets under construction), private companies will be required to disclose all contracts, or portions of contracts, granting “control” of the leased asset for a specific period of time.

The scope of the changes is clear from these major changes required by ASC 842:

  1. Leases must be classified as either finance leases (formerly referred to as capital leases) or operating leases. To be categorized as a finance lease, the lease must meet at least one of these criteria:
    1. The lease term covers most of the asset’s remaining economic life;
    2. The asset is specialized for the lessee’s use;
    3. The present value of the sum of the future minimum lease payments exceeds “substantially all” of the fair value of the asset;
    4. The lease either
      1. Transfers ownership to the lessee at the end of the lease term, or
      2. Gives the lessee the option of purchasing the asset, and there is reasonable certainty that the lessee will exercise this option.
  2. The rules for operating leases depend on the term of the lease. That is the first determination that must be made.
    1. Short-term leases are leases that run a term of 12 months or less. In addition, the lessee may not have the option of purchasing the asset at the end of the lease term.
      If the lease is deemed a short-term lease, the lessee may be able to recognize the lease payments over the lease term on a straight-line basis without having to include it on the balance sheet.
    2. Long-term leases are treated differently. For example, lessees will be required to record lease assets (i.e., the lease liability adjusted for certain items such as prepayments and initial direct costs) and lease liabilities (i.e., the present value of lease payments) on their balance sheets.
  3. The following key terms should be understood before your contracts are reclassified:
    1. Right-of-use asset. The right-of-use asset pertains to the lessee’s right to occupy, operate or hold a leased asset during the rental period.
    2. Embedded lease. Contracts sometimes have leases embedded in them. For example, a service contract that specifies the use of specific assets contains an embedded lease.
      Embedded leases are subject to ASC 842, which states: “A contract is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.”
    3. Lease component. A lease component is the right to use an underlying asset.

The disclosure requirements under ASC 842 are complicated. They require digging deep into contracts and leases, which means businesses need to start preparing now. To achieve the transparency ASC 842 is aiming for, a company must, at a minimum:

  • Take inventory of every lease the company has signed.
  • Categorize assets as real estate, equipment, an embedded lease, a variable payment or right-of-use. This is in addition to classifying the assets as operating leases or finance leases.
  • Lease and non-lease components need to be identified and separated because they are accounted for differently.
  • Amortization schedules must be prepared for assets, such as lease liabilities and right-of-use.
  • To ensure compliance going forward, determine which internal controls need to be revised and where new ones are needed.

Performing the many analyses needed for compliance with ASC 842 is both time-consuming and complicated. Companies need to be sure they have the guidance, tools and technology they need to help ease the process initially and in the future. Getting qualified professional advice is essential.

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