Nonpublic companies and nonprofit organizations are out of time to implement the new lease accounting standard in accordance with Accounting Standards Codification (ASC) Topic 842. Public companies have already adopted this ASU, but after multiple extensions, the adoption date for nonpublic companies and nonprofit organizations is for fiscal years beginning after December 15, 2021. That means calendar year-end companies were required to adopt the standard on January 1, 2022, when reporting in accordance with U.S. generally accepted accounting principles.
The new standard requires organizations to bring all leases over 12 months onto their balance sheets. This means operating leases currently disclosed as commitments will be brought onto the balance sheet as right-of-use assets and lease liabilities. The adoption of the new leasing standard for public companies is estimated to have added trillions of dollars in operating lease liabilities to balance sheets in the U.S. The significant increase in liabilities and right-of-use assets can potentially impact financial ratios and bank covenants.
Before implementing the new leasing standard, organizations must make certain policy elections ranging from how to handle short-term leases to how and when to implement the standard. Following is a brief discussion of a few of the elections:
Lessees may elect NOT to apply the new lease standard to leases of 12 months or less.
This means lessees would not recognize a right-of-use asset and lease liability related to these contracts. If this election is made, the lessee would follow previous lease accounting guidelines to recognize the lease payments as income or expenses on a straight-line basis over the lease term.
Lessees may elect to account for leases and non-lease components as a single combined lease component.
For example, common area maintenance charges are considered non-lease components often paid as a part of a lease agreement. If this election is made, there would be no need for a lessee to consider allocations between different kinds of expenses and will save time during the reporting process.
If the rate implicit in the lease is not readily available, nonpublic entities can elect to use the risk-free rate in lieu of determining an incremental borrowing rate.
In order to include right-of-use assets and lease liabilities on the balance sheet, future cash flows will need to be discounted by an interest rate. If there is a stated rate in the agreement, that would be the default.
If there is no stated rate, the organization can choose between its incremental borrowing rate and the risk-free rate. Given that interest rates were at an all-time low at the beginning of the effective year, the difference in rates could have a significant effect on the adoption year balance sheet.
To determine if a lease is considered a financing lease or an operating lease, organizations can make policy choices that define two of the four criteria.
These two criteria are as follows:
- The lease term is a major part of the economic life, and
- The present value of the sum of lease payments equals or exceeds substantially all of the fair value of the underlying asset.
The organization now has the ability to define the terms “major part” and “substantially all” either for all leases or by asset class. These rules help determine the distinction between financing and operating leases. The term “capital lease” will be phased out by the standard in exchange for the term “financing lease.”
Additional policy choices the organization can elect:
- Early adoption of the accounting standard.
- Certain practical expedients related to existing leases would provide relief in the transition.
- How it presents operating and financing right-of-use assets and liabilities separately, either on the balance sheet or in the footnotes.
Required adoption is here; therefore, it is time to start planning for how it will impact your organization. Windes offers a streamlined service to help organizations through the process of adopting the new lease standard, including centralizing lease tracking and reporting, organizing lease documents, generating reports and journal entries for monthly and annual close processes, and financial statement presentation and related disclosures.
For questions or more information, please contact Jeffrey Ehlers at email@example.com or 844.4WINDES (844.494.6337).