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Authored by Paul Dunn and Jeff Weinberg

The new lease accounting standard, ASC 842, is intended to increase transparency and comparability of financial information among organizations through the recognition of lease assets and lease liabilities on the balance sheet and the disclosure of key information about leasing transactions. ASC 842 is a part of a broader set of convergence goals which includes aligning U.S. generally accepted accounting principles (GAAP) lease accounting standards promoted by the Financial Accounting Standards Board (FASB) with other major standards-setting authorities like the International Accounting Standards Board.

While the adoption of ASC 842 has been previously deferred twice for non-public entities, the new lease standard is now effective for fiscal years beginning after Dec. 15, 2021 for all non-public entities. Therefore, it is critical for entities that have not yet adopted ASC 842 to begin the process now by examining their lease portfolio and evaluating their level of preparedness. Financial reporting changes resulting from the adoption of ASC 842 may also impact debt covenants, KPIs, cost of capital decisions and other strategic planning efforts. As a result, many entities will require an assessment of the potential impact of ASC 842 on their financial reporting even before implementation of the new standard is complete.

The topics below illustrate a few areas where public entities have experienced challenges upon adoption of ASC 842.

While the following considerations are not an all-inclusive list of the challenges that can be expected upon adoption of ASC 842, they are illustrative of the complexity involved with implementation of the new lease standard. 

Achieving completeness with respect to all lease arrangements and related amendments can be both challenging and time-consuming. Identifying all lease arrangements will need to be a cross-functional effort within the organization. Consequently, entities have found that procuring the complete and final documentation for their leases has been a challenging task since many of the agreements are either located at a business unit or may be incomplete. This can result in delays in the ASC 842 adoption process which can take weeks or months to complete even once all lease documentation has been compiled.

Further complicating this process are other contractual arrangements which might not have been identified as leases under prior guidance (ASC 840) and may need to be evaluated to determine if the agreements should be classified as leases either in part or in whole. As per ASC 842, an arrangement is or contains a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Application of this definition could result in agreements such as certain supplier arrangements and service contracts containing embedded lease arrangements that will have to be further reviewed to determine the amount of consideration that will need to be allocated to the lease and non-lease components in the agreement. 

Properly abstracting key lease terms can also create complication in the recording of leases under ASC 842. The lease component is the payment, or portion of the payment, that is associated with the right to use an underlying asset. Non-lease components, such as common area maintenance, transfer a good or service to the lessee. Non-components, such as insurance and real estate taxes, are costs incurred by a lessor whether or not the asset is leased. Once the various components of a lease payment have been identified, it will be necessary to define whether each lease component is considered fixed or variable to determine the minimum lease payments to be capitalized in the right-of-use (ROU) asset and lease liability recorded on the balance sheet. For example, fixed lease components and variable lease components that depend on an index or rate (e.g., CPI) will need to be included in minimum lease payments.

The FASB has provided a practical expedient that can be elected to allow entities to combine lease and non-lease components and account for them as a single lease component. However, this election will increase the amount of the lease payments that are included in minimum lease payments and ultimately result in a higher lease liability. Therefore, entities will need to carefully consider the financial statement impact of electing this practical expedient.

Compliance with ASC 842 may necessitate the use of new lease administration software for entities that have even a modest number of leases (e.g., 20 or more leases) in their portfolio. Lease administration software allows organizations to maintain their lease data and documentation in a centralized database. This can be extremely helpful, not only for the adoption of ASC 842, but also for ongoing financial reporting needs as existing leases may be modified or new leases added within the lease portfolio. Most importantly, lease administration software provides the entries, amortization schedules and quantitative portion of the leases footnote disclosure that entities would otherwise have to calculate in a spreadsheet. The efficiency and accuracy of utilizing lease administration software versus a spreadsheet adoption tool has resulted in many entities choosing this option despite the additional time and cost required to do so.

Under ASC 842, the IBR is defined as the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term, an amount equal to the lease payments in a similar economic environment. As explained below, this determination can require significant effort and judgment by management.

Consideration should be given in determining an IBR for each lease and might require an upward or downward adjustment to the organization’s beginning base debt rate to achieve a final IBR. The list of considerations that may impact the final determination of the IBR include, but are not limited to, lessee-specific credit risks, lease payment amounts, lease payment structure, collateral nature of the leases, quality of the lessee’s collateral, economic environment of the lease and foreign currency exchange risks. Once an appropriate final base IBR has been determined, it must then be adjusted/interpolated to the appropriate range of lease terms to develop an IBR rate table for the various lease terms (or remaining lease terms) to be used upon the adoption of ASC 842.

Month-to-month leases (or in some cases, quarter-to-quarter or year-to-year leases) are those agreements with a lease term of one month or less that may be canceled by either the lessee or lessor without significant economic penalty and with no more than 30 days’ notice to the other party. These leases might be considered month-to-month based on the original lease terms and management’s judgment of whether or not it is likely the lessee will continue to lease the asset for a longer period of time. Conversely, these leases might have originally had a stated lease term of greater than 12 months, but have gone into a month-to-month holdover period or auto-renewal status following the initial or extended terms since neither party has formally executed a new renewal, an extension option or a replacement lease agreement.

These types of leases require special attention and judgments that management will need to make to arrive at the appropriate lease term. This determination is critical as it will ultimately result in these leases either being considered short-term, and treated in a manner similar to how operating leases were accounted for under ASC 840 (straight-line basis), or being capitalized on the balance sheet as a ROU asset and lease liability. Further, calculation of the lease term will influence both the amount of the minimum lease payments as well as the amortization period of any recorded leasehold improvements that are associated with the lease. 

Conclusion

Non-public entities have a great opportunity to learn from public entity implementations of the new lease standard by researching public disclosures both in the year of ASC 842 adoption and post-adoption periods. Non-public entities can also benefit from public entity experiences when making decisions about investments in lease software solutions. The FASB’s deferral of the adoption date for non-public entities has provided welcome relief to organizations that are already overwhelmed by the many challenges to their operations caused by the pandemic and working remotely. However, implementing the new lease standard is now a primary focus for most finance organizations.

For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.

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