Are You Ready for the New Lease Accounting Standard?

By Steve Carter, CPA, Principal

The COVID-19 pandemic created unique conditions for businesses in the Bay Area and across California. The combination of forced business closures and stay-at-home orders left many companies in uncharted waters. Some were forced to close while others had to find new ways to deliver products and services to customers. At the same time, many were searching for new lines of credit, business loans, or other ways to access working capital. It was against this backdrop that FASB made the decision to delay the implementation of ASC 842 (new lease accounting rules) by one year, starting with reporting periods after December 15, 2021. Although early adoption was permitted, many decided to delay implementation to focus on pandemic-related issues. As the recovery continues and year-end is just a few months away, businesses need to re-examine the new lease accounting rules to ensure compliance.

On November 10, 2021, the FASB Board decided not to provide a third effective date deferral of Topic 842 for entities within the scope of paragraph 842-10-65-1(b) (generally private companies and certain not-for-profit organizations).

New Lease Accounting Rules

The purpose of ASC 842 is to bring most operating leases onto the balance sheet. Why the change? The new standard is meant to give investors and other stakeholders a clearer, more accurate picture of a company’s financial position. The proper disclosure and classification of leases will help to drive additional transparency.

The new rules retain the two-model approach of classifying leases as operating and finance leases. However, majority of leases must now be recorded on the balance sheet including finance lease right-of-use assets, finance lease liabilities, operating lease right-of-use assets, and operating lease liabilities.  This is a stark difference to earlier standards, which only required finance (formerly known as capital) leases to be disclosed. Short-term leases of 12 months or less are permitted to be excluded as a matter of accounting policy.

What constitutes a “lease” is also changing. This may expose companies with contract provisions not previously classified as leases to have a new reporting requirement. At the heart of the definition is control: if the lessee maintains substantial economic benefits from the asset and has the right to direct its use, then it may be considered an embedded lease. Identifying contracts that have embedded leases and how to recognize/disclose them will be an ongoing challenge for many.

Classifying a Finance vs. Operating Lease

Under the new guidance, a lease must be classified on the date the asset becomes available for use. For example, expenses on an operating lease would be recognized using a straight-line basis while finance lease expenses would be recognized both as interest and amortization expense.

If a lease meets at least one of the following criteria, it is a finance lease:

  1. Ownership transfer at the end of the lease term
  2. Lessee retains the right to purchase the asset
  3. The lease term is for the rest of the asset’s economic life, except when the commencement date occurs at or near the end of the asset’s useful life
  4. Lease payments and any residual value reflect the equal or excess of the asset’s fair value
  5. The asset is specialized in nature and wouldn’t benefit the lessor at the end of the lease term

If none of the above criteria are met, the lease is generally classified as an operating lease. Reasonable judgment must be applied to each circumstance; for example, how much remaining useful life does the asset have, or how much fair value is present.

The changes outlined in ASC 842 will require companies to conduct a comprehensive examination of leases and contracts, to determine what additional reporting may be required. Many companies will need to conduct several weeks of analysis and calculation before preparing the necessary disclosures. If you have questions about the new lease accounting changes, please contact us or give us a call at, 408-377-8700.