Clearing the Hurdles to Implementation in Your Organization
The multi-year delays in implementation of the new lease accounting standard are over and now it’s go time. This is it, and if your company or nonprofit has not yet started gathering the information necessary to properly report its lease obligations for 2022, there is no more time to waste.
The new lease accounting standard – ASC 842 – has been more than 10 years in the making and has been subject to multiple implementation delays, the most recent due to the COVID-19 pandemic. It took effect last year for public companies and is effective this year (technically, for fiscal years starting after December 15, 2021) for private companies and nonprofit organizations.
The primary objective of the new standard is for lessees to report a liability or obligation with transparency. Previously, lease obligations were disclosed in the financial statement as a commitment. But if you’re locked into a lease, it’s really a liability. As such, it has now moved to the balance sheet and the present value payment stream is reported as a liability, with an offsetting entry quantifying the “right of use” to which the lease entitles you. The imputed interest rate can be calculated in different ways, and the Financial Accounting Standards Board (FASB) recently issued an expedient way to use the fed funds discount rate to determine the present value of the payment stream.
For example, a two-year lease on a photocopy machine may be reported as a liability at $200 a month, or $4,800 over the life of the lease. The offsetting entry would report the right to use the photocopy machine for 24 months, valued at $4,800.
But there are nuances. You may have a lease that starts today and ends five years from now. But if there is a renewal option for another five years and you’re reasonably certain to exercise that option, it’s really considered a 10-year liability and you would need to determine the 10-year payment stream. The good news is that it does not trigger any restatements.
Other tricky situations can arise with companies that set up their own real estate entities to lease facilities back to the parent company. This is common and not always as fully documented as it should be. Sometimes there’s a written lease and other times the arrangement is on a month-to-month basis.
Under the previous financial reporting standard of “economic substance,” the intent of the parties was taken into account.
The new standard is based on “legally enforceable terms” (instead of economic substance). This means if either party can terminate a lease without significant consequence, there may be no actual lease liability. This can have significant consequences if you have made leasehold improvements to a building. Under GAAP, leasehold improvements are amortized over the shorter of the useful life of the asset or the term of the lease. But if there is no lease, you may be facing a large write-down and a significant hit to your income statement. This could trigger a domino effect on various ratios and financial covenants.
So, it’s important to document related-party leases. You may have been comfortable with a casual “verbal” lease from your own organization in the past, but that could come back to bite you under the new standard.
The biggest problem with implementation of the new lease standard appears to be procrastination. Industry surveys indicate about half of private companies have implemented the new standard or are in the process. That means half have not done so, and we are well into the implementation period. While the new lease reporting standard does not have to be applied on an interim basis in 2022, if you get to December without having started this project, there will be pain.
The first step toward implementation should be to gather an inventory of your leases. Organizations often don’t realize how many leases they have or where they are. Some contracts included embedded leases that are not apparent without a careful reading. The process of documenting all your leases involves a lot of data and information gathering.
Once the lease inventory is determined, have a discussion with your accounting and finance advisors about the best way to comply with the new reporting standard. Tracking them on a spreadsheet is fine but requires constant updating and monitoring. Lease tracking software may help.
Talk with Lenders
Another important step in the implementation process is to talk to your lender about how shifting leases to the balance sheet may impact your loan covenants. Bankers generally have been educating themselves about the new lease standard, but a proactive meeting could help avoid surprises.
If you would like to have a conversation about how to implement the new lease accounting standard in your organization, the time is now. Contact your Rea advisor.
By Jim Suttie, CPA (Mentor office)