The Financial Accounting Standards Board’s (FASB’s) new lease accounting standard will become effective for private companies and not-for-profits beginning with fiscal years that start after December 15, 2021. The 2022 calendar year will be the first that most companies who issue financial statements under U.S. generally accepted accounting principles (GAAP) will have to adopt the new guidance.
In February of 2016, the FASB issued Accounting Standards Update (ASU) 2016-02, Leases. The standard, codified at Topic ASC 842, Leases, replaces long-standing guidance for lessors and lessees that had previously existed for decades.
For most entities who issue financial statements under U.S. GAAP, several delays have provided additional time for private companies and not-for-profits to implement the new standard. In November of 2021, the FASB declined to provide any additional delays.
The new lease accounting standard will impact businesses across all industries that lease physical space or finance the acquisition of equipment and vehicle fleets through lease arrangements.
Under the guidance, a lease is now defined as conveying the right to control “the use of an” identified asset to a customer and where the customer obtains substantially all its economic benefits.
Most leases will now be presented on the balance sheet in the form of right-of-use assets and lease liabilities. The exception will be for leases that elect the short-term lease accounting policy which will be limited to arrangements with a term of 12 months or less and where there is not an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
The right-of-use asset is subsequently amortized over the lease term or the useful life of the underlying asset, depending on whether the lease has been classified as a finance lease or an operating lease. Lease liability is measured at the present value of future lease payments using the discount rate implicit in the lease, if available. This rate in a lease may not be easily determinable by the lessee, in which case the lessee’s incremental borrowing rate will be the appropriate discount rate to use in measuring the lease liability.
For example, you are the lessee of a retail space who has just entered into a 10-year lease for 5,000 square feet of space at an annual rate of $100 per square foot. Under the prior standard, you would report on your income statement the straight-line annual rent expense incurred during the period and no amounts would be recorded on the balance sheet for the lease. Assuming no annual rent increases, you would report annual rent expense of $500,000 with no initial balance sheet measurement. Under the new guidance, you would calculate the present value of the 10 years’ worth of lease payments using the rate implicit in the lease or the lessees incremental borrowing rate and this would represent the initial right-of-use asset to be amortized and the lease liability.
New lease terms
The lease term is comprised of the noncancellable period of the lease. This includes considerations of periods covered by options to extend the lease that the lessee is reasonably certain to exercise, those where the lessor has the option to exercise, and termination clauses within a lease. When a lessee or lessor can terminate the lease without permission from the other party and there is no more than an insignificant penalty, the lease term would run until such a date unless it was reasonably certain the lessee will not exercise such a right.
Accounting for lease arrangements under ASC 842 should have started with the beginning of the calendar year. If your finance team has not already done so, they should be working to identify all lease arrangements and summarizing key terms. Initial calculations of right-of-use assets and lease liabilities should be measured, and amortization of lease terms should be accounted for in the current reporting period. Those involved in the reporting process should also be compiling information that will be needed to comply with the new disclosure requirements.
The new lease accounting standard may impact many of the commonly used financial ratios utilized by lenders such as the fixed charge ratio, tangible net worth, and debt to tangible net worth. Companies should evaluate the impact of the new standard on its covenants and have discussions with lenders to ensure there are no problems when reporting occurs under the new standard next year.
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