Leasing, whether it’s real estate or equipment, can be a valuable tool for your business and financial operations. Whether it’s a lease for your office space, a cross-country network of warehouses, vehicles, machinery, or copiers—it’s likely you have at least a few leases in place.
The Financial Accounting Standards Board (FASB) updated the lease accounting standard (ASC 842) to make the information about leases more transparent to financial statement users. These new requirements are already in place for public companies and the deadline for compliance by other organizations is rapidly approaching. For private companies and non-profit organizations, ASC 842 is effective for annual reporting periods beginning after December 15, 2021. Early adoption is permitted.
While there are a few potential impacts to lessors (those who own the assets), lessees (those leasing the equipment or property) will see the greatest impact from ASC 842. Specifically, if your organization has GAAP reporting requirements, the new standards will impact the process.
Operating leases, previously only disclosed in footnotes, must now be added to the balance sheet. You now need to calculate and record accounting entries to book the value of the leases—called Right of Use (ROU) assets—and record their associated contract obligations as liabilities.
The ROU asset and lease liability for each lease is recorded at the present value of the total rent payments over the term of the lease, including any initial direct costs. The present value is calculated using a discount rate based on the rate implicit in the lease, or the incremental borrowing rate if the implicit rate is not readily available.
Capital leases will remain on your balance sheet and will be renamed as Financing Leases. Be sure to update the verbiage throughout your reporting documents, software systems, and training manuals.
Straight-line rents and escalating payments
Similar to the previous standards, ASC 842 requires rent expense to be recognized straight-line over the term of the lease. Therefore, the amount of rent expense recognized in a reporting period will not change after transitioning to ASC 842.
If the contract includes rent increases in subsequent years of the lease, the difference between straight-line rent expense and the cash paid is still accounted for within the amortization of the ROU asset and lease liability, however, the deferred rent liability used under the previous lease accounting standard is not separately identified on the financial statements under ASC 842.
Related party leases
In short, related party transactions for leased property, plant, and equipment (PPE) need to be recorded in the same manner as unrelated parties. The threshold FASB requires for related party leases is whether there are enforceable terms and conditions to the lease. Written agreements are more easily defined, but verbal related party agreements with implicit understandings may still create enforceable terms and conditions, bearing an equal obligation to recognize the lease on the balance sheet. Appropriate related party disclosures for the arrangements are still required.
Short term leases
Leases that are shorter than 12 months are not required to be recorded on the balance sheet. Short-term lease disclosures are still necessary.
ASC 842 requires a transition using the modified retrospective approach. Under this method, you will record a cumulative-effect adjustment to beginning retained earnings in the year of adoption. Practical expedients are available to ease the transition.
If you have many leases in place for real estate and equipment, the transition will require significant planning. Specifically, the changes with ASC 842 may have a considerable impact on your financial statements. Determining the impact now will allow for earlier and easier discussions with the stakeholders of your company. Contact your advisor at MarksNelson to help implement the standard and factor in other considerations.