At a Glance
Private Companies should seek ASC 842 guidance and consider the implementation efforts needed to meet the new lease accounting standards. This is especially true for those companies with high lease populations or anticipated increases in the number of leases they will have in the future. Companies may also want to factor in utilizing lease technology solutions for assistance with identifying a complete list of leases, collecting all the necessary documentation, evaluating key considerations (e.g., lease term and path forward on incremental borrowing rate [IBR]), performing the calculation, and updating key processes and controls, which require a considerable amount of preparation.
Read on to learn about four key steps every private company needs to consider in order to comply with the ASC 842 lease standards.
Implement a Process to Maintain and Identify Your Complete Lease Population
It can be challenging for organizations to keep track of their real estate and equipment leases. There are some real estate and equipment leases that organizations historically did not consider as leases before ASC 842. Additionally, when organizations do not have a centralized system to track all of their leasing information, mistakes and delays can occur. This is especially true when different functional areas of a company can enter into lease arrangements on their own.
Companies can reduce the effort involved in identifying all leases by centralizing their tracking process. By doing so, contractual arrangements are contained within a central repository, simplifying the reporting process on the entire population of leases.
After implementing the standard, this new formalized process will place all lease considerations into a controlled environment. Any future contractual arrangements should then be routed to the relevant individual, department, or system to determine if they should be included in lease accounting. Quarterly and annual financial reporting efficiencies can be created, saving time with future contracts.
Review Lease Renewals
One key input into the lease liability and right-of-use (ROU) asset calculation is the lease term, which is not always straightforward when considering renewal, termination, or purchase options.
A good example is when a company enters into a shorter-term lease period, fully intending to use the asset for a longer lease term. Even though the stated term is shorter than 12 months, the company will likely exercise renewal options. This strategy can provide flexibility for price negotiation in the future; however, when there is a level of certainty in renewal, the estimated term, taking into account renewals likely to be exercised, needs to be the term used in calculations. Having an explicit term of fewer than 12 months does not default the agreement as being outside of capitalization when renewal options exist.
There is no absolute certainty when it comes to leases. Over time, lease terms may change. However, if there is a pattern of adjustments to the estimate over consecutive years, it could raise questions with your auditors about the assumptions and inputs used to calculate the value of the lease.
Identify the Advantages and Disadvantages of Calculating an Incremental Borrowing Rate (IBR)
Private companies may elect to use a risk-free rate instead of the incremental borrowing rate under ASC 842. If you are leasing a property and using the risk-free rate, the company will save time, effort, and money by not having to calculate an IBR, which is the rate a company would pay to borrow the total amount of rent payments under a collateralized loan over the lease term.
This private company election can create future challenges if the company plans to go public. It can also create challenges when performing impairment analysis. If a company chooses to make this election before going public, it will have to undo all private company elections, using time and resources that could be better used to prepare for the IPO.
Additionally, the risk-free rate is generally lower than the IBR that would be calculated, which means that the carrying value of the ROU asset will necessarily be higher. This higher carrying value may increase the likelihood of the asset being impaired when testing for impairment.
Consider the Impact of Impairment Requirements
Traditionally, when companies leased property, impairment never really mattered with leases because they were not considered an asset on the balance sheet. But now that leases are technically treated as assets under ASC 842, they are subject to impairment testing. This means a lease will need to be tested for impairment like any other long-term asset. An ROU asset is impaired when its carrying value is less than the fair value.
Windes can help
Windes’ experts can provide the ASC 842 guidance your organization needs by addressing disparities between where your company currently stands on lease accounting and where it needs to be for compliance with the new standard. Contact Windes today.