Private Company ASC 842 Adoption: Getting Ready

For finance and accounting professionals adopting the lease accounting standard ASC 842, here’s an overview of the standards and some recommended implementation steps.

Key Information

  • Effective Date – ASC 842 is effective for private companies for fiscal years beginning on or after December 15, 2021 (i.e., in the annual financial statements of companies with calendar years beginning on January 1, 2022), and all interim periods ending in calendar years beginning on January 1, 2023.
  • Prior Standard – ASC 840 was the prior leasing standard and only capital leases were reflected as assets and liabilities on the balance sheet while operating leases were off-balance sheet and only disclosed in the notes to the financial statements.

Transition Options and Elections

Management has numerous decisions to make in adopting ASC 842, prior to identifying and classifying leases and creating your lease schedules, journal entries and disclosure notes.

  • Transition Methods – companies will adopt one of the two transition methods available.
    • Comparative method
      • Applies at the beginning of the earliest comparative period, for example – January 1, 2021 for companies with a December 31, 2022 year end.
      • Required to adjust comparative periods as if ASC 842 had been in effect for those periods.
      • No revisions to the accounting for leases that expired prior to the date of initial application.
    • Effective date method
      • Applies at the beginning of the fiscal period you adopted the standard, for example – January 1, 2022 for companies with a December 31, 2022 year end.
      • No requirement to adjust comparative periods or provide comparative period ASC 842 disclosures (however, in the earlier period, the ASC 840 disclosures are to be included)
  • Practical Expedients – to assist in the adoption of the new standard, companies should consider all the practical expedients available in accounting for lease agreements.
    • Package of Three – must be elected as a package and applied consistently to all leases. Classification of leases under ASC 842 will be the same as the previous classification determined under ASC 840.
      • You do not need to reassess whether a contract or an expired contract contains a lease,
      • You do not need to reclassify any existing or expired lease as determined under ASC 840, and
      • You do not need to reassess any previously reported uncapitalized initial direct costs for any leases.
    • Use of hindsight – hindsight is allowed when considering judgments and estimates such as:
      • Determining the lease term (i.e., evaluating a lessee’s option to renew or terminate the lease or to purchase the underlying asset), and
      • For lessees, in assessing the impairment of the right-of-use assets
    • The use of the hindsight practical expedient may be elected separately or together with the package of three practical expedients described above.
    • Lease easements – a company may elect not to reassess whether land easements that were not previously accounted for as leases under ASC 840 would require accounting as leases under ASC 842 or was assessed incorrectly under ASC 840.
  • Discount Rates – companies will need to select a discount rate(s) that will be used in calculating the leases liabilities. Three options are available for private companies.
    • Implicit Rate in Lease – should be used before any other rate if it is either known or readily determinable.
    • Incremental Borrowing Rate (IBR)– 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.
      • This is a hypothetical rate which renders it difficult to obtain and document and costly for auditors to corroborate.
      • Factors that may be considered in determining the IBR include – synthetic debt rating to develop a yield curve or analysis of publicly available debt information for similar borrowers.
    • Risk-Free Rate (can be elected only by private companies by class of leased asset) – is the rate investors expect to earn from an investment that carries zero risk over a period of time to maturity that corresponds to the length of the lease term, such as a government treasury bill.
      • Publicly available and easy to obtain.
      • Will normally be a lower rate than either the implicit rate or the IBR and therefore would result in a larger lease obligation and right-of-use asset negatively impacting the balance sheet.

Preparing for Implementation

  • Financial Reporting – calculate the preliminary effects of adopting the standard on your financial statements and ratios. This may include the impact on compliance with bank covenants.
  • Find a Solution – Excel will work if you only have a few leases, lease accounting expertise, and sufficient resources available to devote to adopting and performing lease accounting. If you have a lot of leases and limited expertise, then consider using a specialized lease accounting system.
  • Lease Identification
    • Identify existing leases -a contract 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.
    • Once you have identified contracts that are considered to be leases, you need to test the classification of the lease as being either operating or finance.
    • What to consider – If you answer “yes” to all of the questions below, you have identified a lease.
      • Is there an identified asset?
      • Does the customer (lessee) have the right to obtain substantially all of the economic benefits from the use of the identified asset?
      • Does the customer have the right to control the use of the asset?
    • Type of agreements – a lease could be for a variety of different assets and services such as real estate, vehicles, office equipment, manufacturing equipment, storage, land, and many more.
    • Embedded leases – Not every contract that contains a lease necessarily uses the word “lease” in the contractual captions or text. An agreement that is captioned as a supply agreement, a service agreement, a contract manufacturing agreement, or an IT outsourcing agreement could contain provisions that are an embedded lease.
  • Lease classification – test the classification of your lease agreements into these lease types using the test criteria set forth in ASC 842.
    • Lessee
      • Operating
      • Finance
      • Short term – a lease under a term of one year.
    • Lessor
      • Sales-Type Lease
      • Direct Financing Lease
      • Operating Lease
  • Separating lease and non-lease components – ASC 842 requires a reporting entity to allocate the contractual consideration between lease and non-lease components.
  • Sublease – identify if you have any sublease arrangements. This is defined as a transaction in which an underlying asset is re-leased by the lessee (or intermediate lessor) to a third party (the sublessee) and the original lease (head lease) between the lessor and the lessee remains in effect.
  • Fair Value of Leased Assets – in order to determine lease classification, the entity must determine the fair value of the underlying asset at the inception of the lease
  • New Disclosures – the objective of the disclosure requirements is to enable users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases.
  • Lease Management – how will you manage your lease contracts and agreements going forward.
    • Lease Administration – what new processes will you need for sharing newly executed lease agreements or potential embedded lease agreements with the Accounting group?
    • Storage – how will store your agreements – centralized or decentralized in lease accounting system?
    • Abstract Leases – it is considered a best practice to create an abstract (or summary of key terms) for each new lease since such agreements are often lengthy and spiked with legalese that can be difficult to understand and apply.
    • Load Leases – leases will be manually or bulk uploaded directly into a new lease accounting system or excel templates to generate your lease schedules and journal entries.
    • Create Conversion Journal Entries – you must generate the journal entries to record the lease liability which is the present value of future lease payments. As well, the right of use asset, which is determined by talking the lease liability and adjusting it for payments made prior to the inception of the lease, initial direct costs, and lease incentives received.

Effects of the Standard

  • Balance Sheet Impact – ASC 842 will impact the Balance Sheet and will result in increased liabilities with corresponding right-of-use assets for leases that were previously classified as operating leases.
  • Income Statement Impact – expense recognition for operating leases is consistent under ASC 840 and ASC 842 where the expense associated with the lease is recognized as expense on a straight-line basis over the term of the lease. For finance leases, the right of use asset is amortized straight-line over the shorter of the related asset’s economic life or the term of the lease.
  • Disclosures – expanded quantitative and qualitative notes to financial statements.
  • Bank Covenants – financial ratios that potentially impact bank covenants will change adversely such as debt-to-equity ratios.
  • Income Taxes – In the U.S., the operating lease right-of-use assets and lease obligations that are recognized for financial reporting purposes will have a zero basis for income tax reporting purposes, thus giving rise to deferred income tax assets and liabilities.
  • Internal Controls – internal controls and business processes will need to evolve to ensure that all aspects of this complex standard are addressed in a timely manner.

Black Owl Systems helps finance leaders of large and small private companies reduce the frustration of adopting and accounting for ASC 842 by reducing compliance risks, enabling them to complete lease accounting faster and more accurately.

This discussion is intended to present a summary of the steps a private company must take to prepare for the adoption of FASB Accounting Standards Codification (ASC) Topic 842 and is not considered a complete representation of the standards.

Greg Kautz
Greg Kautz

Greg Kautz, CPA, CMA

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