Most public companies reporting under US generally accepted accounting standards (GAAP) have adopted the new lease accounting standard. While the Financial Accounting Standards Board (FASB) granted private entities additional time, the effective date is fast approaching.
For private companies, the standard applies to fiscal years beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022. Many private entities have delayed adoption due to time and resource constraints.
Private companies should consider starting implementation efforts as early as possible as the adoption process often takes more time and effort than they anticipate. Entities with a significant number of leases, especially ones that are international or otherwise not homogenous in terms of structure and key terms, may need months to complete the standard implementation from start to finish.
The most significant change in Accounting Standard Codification® (ASC) Topic 842, Leases, involves the lessee model, which requires lessees to record right-of-use assets and lease liabilities on the balance sheet for almost every lease.
This significantly differs from legacy accounting for operating leases under which leases were viewed as executory contracts not recognized for accounting purposes. Accordingly, these operating leases were solely disclosed in the notes to the financial statements as future commitments, instead of recorded on the balance sheet.
Under ASC Topic 842, entities will record a right-of-use (ROU) asset that represents the lessee’s right to use an asset over the term of the lease. By requiring operating leases to be recorded as a ROU asset and a lease liability, the standard ensures all in-scope leases are recorded on the balance sheet.
The new standard also contains a variety of practical expedients and policy elections. For example, as a policy election, entities can elect not to apply the recognition requirements of ASC Topic 842 to leases with a term of 12 months or less at the commencement date.
Why It Matters
Adopting ASC Topic 842 can affect key financial decisions for organizations across industries that use leases.
For example, entities may find themselves with lower liquidity ratios or higher working-capital turnover due to the recognition of additional lease assets and lease liabilities on their balance sheets. This could impact their ability to seek additional credit or investment or affect compliance with financial covenants.
Ultimately, implementation of the new lease accounting standard will require a thorough planning and assessment process to help ensure a successful and complete transition.
A Three-Phase Approach
The following section provides details on three essential elements for an efficient transition and effective implementation.
Phase One: Planning
Organizations can benefit from creating a task force of internal and external finance professionals capable of assessing the impact of adopting ASC Topic 842 as well as skilled enough to put it into practice.
The new standard means external auditors will also look at the processes for the first time.
Entities will want to involve auditors early and include them on their planning team. This will enable auditors to provide input during key phases of the implementation process, as well as insight into any conclusions.
Step One: Assess Leases
Planning teams should assess the key characteristics of their organization’s leases.
It’s important to assess:
- Variable lease payments
- Key options, such as renewals, terminations, and purchase options
- Residual value guarantees
- Types of initial direct costs
- Service contracts that could include leases
Planning teams should discuss and obtain the approval of management, and in some cases relevant stakeholders, regarding the selected transition method.
ASC Topic 842 requires a modified retrospective transition, with the cumulative effect of transition, including initial recognition by lessees of lease right-of-use assets and lease liabilities for existing leases, as of either:
- The effective date. Under this method, the entity’s comparative reporting period is unchanged; comparative reporting periods are presented in accordance with legacy US GAAP—that is, ASC Topic 840—while periods subsequent to the effective date are presented in accordance with ASC Topic 842.
- The beginning of the earliest comparative period presented.
Step Two: Identify Lease Population
The teams then need to identify their organization’s lease population and determine their scoping approach. Key to this step is ensuring the completeness of the lease population because operating leases previously weren’t on the balance sheet.
Companies may want to consider performing and documenting various completeness procedures such as reviewing the entity’s disbursement registers for any recurring payments and discussing contract types with those individuals charged with negotiating and executing contracts.
Additionally, the new guidance includes an increased focus on embedded leases in other contracts, such as service arrangements.
This step includes determining whether to apply the guidance on a contract-by-contract basis, or take a portfolio approach that can accommodate leases with nearly the same contract terms and data elements.
Step Three: Create a Roadmap
The final step in the planning phase is creating a realistic roadmap that includes:
- Clear implementation stages
- Key achievements and associated deliverables for each stage
- A transition timeline, including a completion date
Phase Two: Assessment and Financial-Statement Impact
Step One: Identify Contracts
Determining whether a contract contains a lease under the new standard includes determining whether an entity has the right to control the use of an identified asset.
To do so, teams must answer two key questions:
- Does the entity have the right to gain substantially all the economic benefits?
- Does the entity have the right to direct the use of an identified asset?
If the answer to both questions is yes, then the contract contains a lease. If the answer to either question is no, then there’s no lease.
Step Two: Evaluate and Record Lease Contracts
Once leases have been identified, organizations will need to evaluate and record their lease contracts. The scoping considerations identified during the planning phase—contract-by-contract or portfolio approach—are critical at this juncture.
Entities will need to do the following:
- Document methodologies and rationale for conclusions
- Develop accounting calculation logic
- Record related journal entries for respective financial statement periods
Then, there are two critical areas to address for each identified lease:
- What type of lease it is—operating or finance?
- What costs within the lease need to be recorded and which are exempt? These will impact important financial documents, such as balance sheets, statements of operations, and cash flow statements.
Entities may elect the package of practical expedients to not reassess the following:
- Whether any expired or existing contracts contain leases under the new definition of a lease
- Lease classifications for any expired or existing leases
- Whether initial direct costs for any expired or existing leases qualify for capitalization under ASC Topic 842
Additionally, an entity can elect on its own or with the package of practical expedients, the use of the hindsight practical expedient.
This practical expedient allows for the use of hindsight in assessing the likelihood that lessee options to extend or terminate a lease or purchase the underlying asset will be exercised.
Despite the practical expedients, identifying operating and finance leases remains essential. Accounting for finance leases under ASC Topic 842 and for capital leases under the legacy lease standard are similar because they both require a lessee to record an asset and liability for the present value of the lease payments.
Unlike finance leases, however, accounting for operating leases is substantially different under the new standard.
During this phase of the implementation process, organizations should focus on six specific areas:
- Determine the lease term by considering extension, renewal, and early-termination clauses
- Account for purchase options
- Identify lease payments
- Account for variable lease payments
- Determine the discount rate or the incremental borrowing rate to use to calculate the present value of operating or finance lease payments
- Account for a lease arrangement’s initial direct costs
Companies should also carefully assess the appropriate financial statement presentation and disclosure; for instance, one frequently overlooked area is that the new standard requires that finance lease right-of-use assets and operating lease right-of-use assets be presented separately from each other on the balance sheet—either in separate financial statement line items or within another separate financial statement line item.
Entities should consider reviewing the financial statement disclosure requirements early to ensure completeness and compliance with the ASC Topic 842.
An assessment entails a significant amount of work and detail, but it will better position entities to apply the new standard to their financial operations in a way that meets compliance and reporting requirements.
Phase Three: Post-Implementation
After adopting ASC Topic 842, entities must make sure they’ve addressed all necessary changes to operational requirements.
This includes the following:
- Develop updated accounting policies, including the creation of new general ledger accounts for more streamlined financial reporting and disclosure preparation
- Identify and implementing new business processes and systems, including IT systems, required for ongoing compliance
- Create new post-implementation internal controls
Once these operational requirements have been rolled out, organizations can benefit from performing periodic post-implementation reviews. These reviews can help verify newly implemented processes and internal controls are operating effectively.
The more lease transactions in an entity’s portfolio, the longer the transition is likely to take. Regardless of size, however, adoption of ASC Topic 842 will require a great deal of dedicated time, resources, and collaboration, and shouldn’t be underestimated.
Putting the right team in place, breaking down the implementation into manageable phases, and enacting the necessary operational processes and procedures for compliance will be key to a successful transition.
We’re Here to Help
Learn more about the new lease accounting standard in our Guide. For help adopting the new standard, contact your Moss Adams professional.