Mike Ford is the Managing Director and Founding Member of PBO Advisory Group.
Lease accounting is becoming more complex and detailed for private companies and not-for-profit entities. Business valuations may also be impacted by the new standard.
Effective in fiscal years beginning in 2022, financial reporting standards require businesses to capitalize on certain leasing activities in the company’s financial statements. Off-balance sheet reporting will be all but eliminated while disclosure requirements expand, according to the Financial Accounting Standards Board’s (FASB) Leases (Topic 842) amendment to the Accounting Standards Codification (ASC), which was issued in 2016.
This means potentially more liabilities on a company’s balance sheets affecting leverage ratios, working capital and liquidity. It’s worth noting that experts such as myself agree that income taxes are generally not expected to be impacted by the new lease rules.
Although the ASC’s guidance states that reporting under these new requirements is not due until your 2022 filings, companies should start determining now which leases apply to the new requirements as detailed in the ASC. Companies should also begin to ascertain how to convert lease activities onto their balance sheets.
ASC 842 went into effect for public companies in 2019, but the Covid-19 pandemic delayed the deadline for private companies and nonprofits. When the updated guidance was issued, the FASB said in a news release that it is intended to “improve financial reporting about leasing transactions” by creating more transparency and comparable information among leaseholders for investors.
Leases Included In ASC 842
The new requirements impact operating leases primarily. These leases include those for office buildings, warehouses, retail space, equipment and more. Compared to a finance lease, an operating lease does not provide an opportunity for the lessee to gain ownership over the asset.
Excluded from the new requirements are leases for short-term rentals (less than 12 months), intangibles and others as well as service arrangements.
For example, if a company has a lease on a specific vehicle for the purposes of transporting parts and products from one facility to another, and that vehicle is solely in control and operated by the company, then it could be considered a lease under ASC 842, and experts agree. However, if the company has a contract with a courier service, and the vehicle used for transportation is utilized at the service provider’s discretion, that is not likely considered a lease that requires capitalization.
A “bundled” lease arrangement should be analyzed closely for applicable lease provisions subject to the new requirements. These contracts usually apply to equipment or communications services. Questions may exist regarding who owns the various parts of the bundle, such as the hardware and software required to operate the equipment or service.
Identify And Categorize Lease Components
Once it’s been determined which arrangements are leases under ASC 842, the next step is to identify all components, terms and amounts within the agreement. The guidance states that the components should be categorized as follows:
• Lease components: items or activities that transfer a good or service to the lessee.
• Non-lease components: other goods or services that may be in the contract, such as common area maintenance, supplies and support.
• Non-components: these include upfront administrative charges, real estate or property taxes and insurance that benefits the lessor.
Then, the lease components are allocated based on relative stand-alone prices unless certain practical expedients are elected in the entity’s accounting policies to avoid that step. Additional considerations on such issues as lease incentives, sales tax on lease payments, variable payments and operating versus finance lease classifications must be made before liability calculation determination.
Start Early And Seek Out Experts
Calculations under these lease accounting requirements can be more complex and detailed than they were previously. Because this process can be extensive, complicated and requires a deep understanding of the new lease standards, it is important that companies begin to prepare now.
To ensure that your business is reporting correctly under the new requirements, you may want to seek guidance and support beyond your internal team. As failure to comply can result in fines and penalties, working with your CPA or an accounting and finance consulting firm may be the right path for you.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.