By Todd Haynes
New lease accounting standards are in effect as of January 1, 2022. ASC 842 applies to nonpublic entities and retains a two-category approach: operating leases and finance leases, which replaces the legacy term “capital leases.”
As lessees, entities must be aware of some big changes in how they evaluate their leases, how those leases are presented on their financial statements and what information is required to be disclosed.
This Q&A addresses important key changes and can help you in your communication with clients.
1. How will the new lease accounting standard impact my balance sheet?
Under the principles of ASC 842, a lessee will include on its balance sheet a right-of-use (ROU) asset and a lease liability associated with its right to use the underlying asset and its contractual obligations to make payments over the term of the agreement.
The lease liability represents the present value of all future remaining lease payments at the commencement date. The ROU asset is the amount of the initial measurement of the lease liability but adds any unamortized initial direct costs and any prepaid lease balances and then subtracts any lease incentives received.
The initial journal entry to record a lease under the new standard would be as follows:
Debit: ROU asset
Credit: Lease liability
The overall impact will significantly increase the total assets and liabilities reported on a lessee’s balance sheet. ROU assets are to be presented as a noncurrent asset, while the lease liability should be broken out between the current and noncurrent portions based on the maturity of future lease payments.
2. How does the new lease accounting standard impact my income statement?
Under ASC 842, the impact on a lessee’s income statement generally will be minimal. The way a lessee accounts for rent expense under the new standard is generally the same as before — straight-line over the term of the lease. Therefore, a lessee’s income statement is not likely to see any significant impacts.
3. How does the monthly accounting change under ASC 842?
Two transactions will need to be recorded every month (assuming the lease requires monthly payments):
- Rent payments
- Amortization of ROU asset and accretion of “interest” on the lease liability
Making the monthly lease payments will result in the following entry:
Debit: Lease liability Credit: Cash
This entry uses the actual cash outlay incurred for the period.
The amortization of the ROU asset account would occur at the end of each month to capture the monthly lease activity by making the following entry:
Debit: Lease expense
Credit: ROU asset
Credit: Lease liability
The amount recorded as lease expense is the straight-line rent expense over the term of the lease. The portion hitting the lease liability account represents the adjustment to reflect the new present value of the remaining payments to account for the passage of time. To calculate this amount, an entity would multiply the current balance of the lease liability account by the monthly interest rate (annual discount rate utilized in the present value calculation divided by 12).
The adjustment to the ROU asset is the difference between the straight-line expense amount and the “interest” accreted to the lease liability.
4. How do I determine the discount rate to calculate the present value of the lease liability?
The standard requires that the rate implicit in the lease, if one is known or readily determinable, be used as the discount rate. If the rate implicit in the lease is not readily determinable, an entity should use its incremental borrowing rate.
The incremental borrowing rate is the rate of interest that the lessee would have to pay to borrow on a collateralized basis over a similar term and amount equal to the lease payments in a similar economic environment.
However, for private companies, a practical expedient is available that allows an entity to use a risk-free rate as the discount rate. Like determining the incremental borrowing rate, an entity must use the risk-free rate for a comparable term to the lease term. This expedient is an alternative for entities that don’t know their incremental borrowing rate, or for which determining an incremental borrowing rate — or multiple incremental borrowing rates for numerous leases — is difficult, burdensome or otherwise too costly.
The risk-free rate is generally a lower rate than an incremental borrowing rate, which leads to a large (less discounted) lease liability and ROU asset, so entities should be sure to consider the impacts of electing expedients.
The risk-free rate is generally easier to obtain than the incremental borrowing rate since readily available and published daily by the U.S. Treasury. However, the risk-free rate is generally a lower rate than an incremental borrowing rate, which will result in a larger (less discounted) lease liability and ROU asset. Therefore, entities should be sure to consider the impacts of electing this and other expedients.
5. Does every lease need to be included in the ROU asset and lease liability?
An entity can consider adopting a capitalization threshold, similar to a capitalization policy for fixed assets, where certain leases could be excluded from the recognition requirements if those leases are immaterial.
It’s important to note that the impact of any such excluded leases needs to be immaterial both individually (for that single lease) as well as in the aggregate (the cumulative potential impact of all excluded leases).
Therefore, when determining and applying a capitalization threshold, an entity will need to quantify not just the amount of the periodic payment or the total annual lease expense but also quantify, among other things, the present value of all future lease payments as that would be more reflective of the balance sheet impact of the lease. Further, an entity should also consider whether excluding leases would be qualitatively material if information about those leases is omitted from the footnote disclosures.
The standard also provides a short-term lease exemption expedient, which allows an entity to not apply the recognition requirements to leases with a term of 12 months or less. The original lease term, including any renewal options reasonably certain to be exercised, must be 12 months or less. However, upon adoption an existing lease with less than 12 months remaining as of the adoption date, but which had an original lease term greater than 12 months, would not be subject to the short-term lease exemption.
6. When should renewal or termination options be included in the lease term?
The lease term is defined as the noncancellable period within the lease, including any periods covered by the option to extend or terminate the lease if the lessee is “reasonably certain” to do so.
Factors that may support “reasonably certain” exercise of a renewal option can include:
- Renewal option period payments are below market rates.
- The lessee made significant leasehold improvements that will still have economic value.
- The lessee would incur significant costs as a result of exercising an option to terminate the lease (i.e., negotiation costs, relocation costs, etc.).
- The leased asset is critical to the lessee’s operations and cannot be easily replaced.
- The location of the leased asset is of strategic importance to the lessee.
Factors that may not support “reasonably certain” exercise of a renewal option can include:
- Renewal option period payments above market rates or reset to fair market value.
- There is a significant period of time before the option can be exercised.
- Other similar types of leased assets are readily available in the marketplace.
- Leased asset does not have strategic value to the lessee.
7. What about month-to-month and annual recurring related party leases? Do these meet the short-term lease exemption?
The guidance remains a little cloudy in this area. The standard states that related party leases should be treated in the same was as any other lease. Most interpretations conclude that this likely means both month-to-month leases and annual recurring leases are not simply 30-day and one-year leases, respectively.
A month-to-month lease acts more as a 30-day lease with automatic renewal options, which would require an entity to determine whether they are reasonably certain to cancel the option or continue to lease the space, and for how long. Similarly, an annual recurring lease would need to be evaluated to determine whether it’s reasonably certain that the lease will renew for another year or more. Absent clarification from the standard setters, this approach is a reasonable interpretation.
It’s worth noting that the guidance on leasehold improvements remains largely unchanged. That is, leasehold improvements are to be amortized over the lesser of the lease term or the useful life. Therefore, if a lessee has concluded that a lease is short-term (either a true month-to-month lease or a single 12-month period), the leasehold improvements would need to be amortized over that short-term period (one month or one year in the examples, respectively).
As such, it is important for entities to carefully consider the language, terms and conditions in their lease agreements as well as the potential impacts when determining the appropriate lease term.
8. What are embedded leases and how are they accounted for?
Embedded leases are leases that exist within or as a part of another contract. For example, IT contracts, maintenance agreements, service contracts or other executory contracts may be or contain leases.
To identify whether an embedded lease exists, an entity should determine whether the four characteristics of a lease exist within the contract:
- Is there an identifiable asset?
- Does the entity have control of the asset?
- Does the contract span a period?
- Is there a component of consideration?
To determine whether the entity has control of the asset, consider 1) if the entity has the right to obtain substantially all of the economic benefit of the asset throughout the lease term and 2) if the entity has the right to direct use of the asset. If both apply, then the contract likely contains an embedded lease.
An example of an embedded lease might be a three-year maintenance agreement for a copier where the entity will purchase all paper, ink, toner and maintenance services from the supplier, and the supplier will provide a copier “free of charge” that will sit at the entity’s site. Even though the contract does not specify that the entity is paying to lease a copier, the copier represents an identifiable asset that the entity will control (it is at their site, and they can use it as they see fit and obtain the economic benefits from it), over a three-year period in exchange for cash payments.
Contracts that contain embedded leases should be bifurcated into lease and nonlease components. In this case, the copier is the lease component — the part of the contract that meets the characteristics of a lease — and the nonlease components are the paper, ink, toner and maintenance services, which transfer a good or service but do not otherwise meet the definition of a lease.
The total contract value should be allocated to the lease and nonlease components based on the relative standalone value of each, with the lease component recognized and accounted for under the new lease standard and the nonlease components recognized and accounted for under other applicable GAAP.
A practical expedient exists that allows a lessee to not separate lease and nonlease components. However, it would require that the entire contract be accounted for as a lease under the new standard. While it simplifies the process by not requiring allocation of the contract value to the various components, it would result in a larger ROU asset and lease liability balance since the entire payment amount is allocated entirely to the lease component.
9. What are the transition options?
Entities have the option of two approaches when transitioning from ASC 840 to ASC 842.
Under the first approach, the entity would apply the recognition requirements as of the date of adoption. This would mean, in comparative financial statements, the presentation and disclosure of the prior year financial information will remain under ASC 840 and the entity will apply the presentation and disclosure requirements under ASC 842 in the year of implementation and going forward. This allows an entity to avoid restating prior reporting periods but may be confusing as the two years presented would not be directly comparable with respect to leases.
The second approach applies the principles of the new standard to both periods presented in comparative financial statements. The presentation and disclosure of the prior and current year information would be adjusted to ASC 842. This requires an entity to apply the recognition requirements as of the earliest date presented in the financial statements, typically the beginning of the prior year.
10. Are there any practical expedients and policy elections available to make the transition easier?
A few expedients can make the transition easier. The first is the package of three practical expedients, which are an all-or-nothing election (i.e., an entity either elects all three or none as part of the package). The package of three expedients include:
- The entity doesn’t need to reassess existing or expired contracts for lease classification (i.e., a lease that was classified as an operating lease under ASC 840 does not need to be reassessed for classification under ASC 842 and can carry forward the operating classification under the new standard).
- The entity doesn’t t need to reassess existing or expired contracts for the existence of embedded leases.
- Initial direct costs for existing leases don’t need to be reassessed under the new definition.
It’s important to note that the package of three expedients does not apply to errors made under the previous standard. That is, a lease that was improperly accounted for as an operating lease under ASC 840 cannot be grandfathered in as an operating lease. Similarly, if a contract was not evaluated for an embedded lease under ASC 840 or was determined to have an embedded lease but was not accounted for as such, it would still need to be reassessed.
The hindsight expedient allows the entity to use hindsight in assessing the lease term and other conditions upon transition. This expedient may be useful if an entity determined that it was reasonably certain that a renewal would be exercised in year one of a lease prior to the transition to ASC 842, but in year two, after the transition, it has obtained new information that indicates the entity is no longer reasonably certain that the renewal will be exercised.
The land easements expedient allows an entity to not reassess existing or expired land easements or rights-of-way for embedded leases. While some land easements may have been accounted for as a lease under ASC 840, others — such as indefinite easements — may have been accounted for as intangible assets.
Further, certain definite-lived easements may have been accounted for as prepaid assets. This allows the entity to effectively carry forward the prior year treatment, as long as the prior treatment was appropriate under the old guidance.
How Wipfli can help
Wipfli’s audit and accounting team can help you navigate the complexities of the new lease accounting standards. You want to be certain your organization is correctly applying the updated rules. Contact us to learn more or continue reading on: