By Matt Luckmann, CPA
At the end of 2018, the Financial Standard Accounting Board’s (FASB’s) new lease standard, known as “ASC 842,” went into effect for all public business entities. FASB delayed the effective dates for private companies to fiscal years beginning after December 15, 2020. However, this should not be a reason for private entities to put off thinking about ASC 842 until next year. Regardless of your entity type, the time to act is now. The new standard significantly changes the way lessors and lessees account for leases, so it’s important to ensure your business is prepared to comply.
In this blog post, I’m going to focus on how the new standard will affect lessees. So, if your business leases a building or equipment, or if one of your contracts contains a lease, here’s what you should know.
What’s changed, and why?
Under the previous standard (ASC 840), lessees would recognize an asset and liability for capital leases; however, for an operating lease, the lease payments would be expensed on a straight-line basis over the lease term. Under ASC 842, all long-term leases will need to recognize a “right of use asset” and a “lease liability.”
ASC 842 also requires more disclosures than ASC 840. These will help users understand the amount, timing, and judgments related to the reporting entity’s accounting, leases, and cash flow, including qualitative and quantitative information.
Finally, whereas ASC 840 used bright-line tests to determine if a lease should be a capital lease or an operating lease, ASC 842 allows for more judgement in determining the lease type.
ASC 842 will provide a more faithful representation of a lessee’s assets and liabilities. By requiring enhanced disclosures, it will also allow for greater transparency about a lessee’s financial leverage and leasing activities.
How are related-party leases impacted?
ASC 842 states that “leases between related parties should be classified in accordance with the lease classification criteria applicable to all other leases on the basis of legally enforceable terms and conditions of the lease.” For example, an informal month-to-month agreement between related parties would be considered a short-term lease. If treatment other than that is desired, the related parties should enter into a legally enforceable contract.
How does ASC 842 impact businesses?
Lessees that have banking covenants should know that ASC 842 may impact certain covenant tests.
Common covenants impacted by ASC 842 include current ratio and leverage ratio.
The new standard may also impact companies that need working capital for bonding purposes because the lease payments due over the next 12 months will be added to current liabilities, reducing working capital.
How do you transition from ASC 840 to ASC 842?
FASB gives businesses two options to transition to ASC 842: modified retrospective or optional method.
Modified retrospective – This option requires businesses to recognize and measure leases at the beginning of the earliest period presented in their financial statements. All years presented in the financial statements will use ASC 842.
Optional method – This requires a retrospective application at the beginning of the period of adoption through a cumulative-effect adjustment. The year of adoption (2021 for private companies) will use ASC 842 and any necessary adjustments will go through retained earnings as of January 1, 2021.
Regardless of the option you choose, you may opt for a single-year financial statement.
To ease the transition to the new lease standard, FASB included two practical expedients as part of the transition process. (Note: Practical expedient #1 must be elected as a package and apply consistently to all leases.)
Practical expedient #1: An entity does not need to reassess each of the following:
- Whether any expired or existing contracts are or contain a lease
- The lease classification for any expired or existing leases
- Initial direct costs for any existing leases
Practical expedient #2: An entity may use hindsight in determining the lease term and in assessing impairment of an entity’s right-of-use asset.
Don’t wait to prepare.
The updated lease standard has arrived, which means now’s the time to discuss covenants and bonding requirements with your financial statement users. Making sure everyone is on the same page will help everyone succeed in light of the change. If you have covenants, consider modifying definitions of covenants to exclude new right of use items or have third party users adjust covenant metrics to account for the changes. Other considerations related to ASC 842 exist beyond the scope of this article, so it’s important to make sure you understand how all aspects of the new standard will impact your business. We’re here to help you implement ASC 842 in a way that makes sense for you, and our CPAs are available to answer any questions you have on the topic. Contact us today to learn more.