Off-Balance Sheet Debt No More – The New Lease Standard ASC 842
Almost 30 years ago, the United States, United Kingdom, Australia, Canada, and the International Accounting Standards Board published a discussion paper that proposed the elimination of an operating lease. Operating leases were contracts or agreements to rent or lease an identifiable asset that was not recorded on the balance sheet as a liability.
After the scandals in Enron and WorldCom, the Financial Accounting Standards Board (FASB) began work on a new accounting standard to close the loophole of this off-balance sheet debt. Finally, ASC 842 was issued by the FASB in 2016 with a final effective date for private companies for annual periods beginning after December 15, 2021, and interim periods beginning after December 15, 2022.
Let’s take a closer look.
What does this mean to you?
All leases longer than 12 months will now be required to be recorded as Right of Use Assets and Lease Liabilities on your financial statements to conform to Generally Accepted Accounting Principles (GAAP). That could put you into a default position on debt for failed covenants, out of compliance with a regulatory agency, or require an explanation to outside users of the financial statements.
What must be done for this new accounting standard?
The first step is to identify all leases. You might think that is an easy question. But what if you hire a construction services provider to renovate your building, and they will use specialized construction equipment for a long time? What if you have a contract with an outsourced information technology company and utilize all their software and hardware? What would a billboard or a Land Easement be considered? Or a copier machine that charges each piece of paper. Are these leases or not?
The second step is to determine the units and allocate the contract. How is a master lease agreement treated? What if a contract includes rights to use land and other assets? How is the standalone price to assign each unit on multiple unit contracts determined?
The third step is gathering the key inputs and classifying the lease. Do you have the implicit rate stated in the lease? If not, what would the incremental borrowing rate be? The incremental borrowing rate is the rate a company in your situation would be able to finance the purchase of the identifiable asset with collateral. What is the lease term, and are you including or excluding renewal options? The last step is recording the Right of Use Asset and the Lease Liability.
What are the effects on your financial information?
That depends on whether they are classified as Operating or Finance. The lease is financed if it meets any of the five following criteria:
- Ownership of the identifiable asset transfers to the lessee by the end of the term.
- An option exists under which the lessee may purchase the underlying asset and exercise of that option is reasonably certain.
- The lease term makes up a major part of the underlying assets economic life (example would be 75%).
- The sum of the present value of the lease payments and any residual value guaranteed by the lessee is equal to or exceeds substantially all the identifiable asset fair value (example would be 90%).
- If the identifiable asset is such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term
It is recorded as an Operating lease if it meets none of the criteria. The initial recording of the Right of Use Assets and the Finance Liability on the financial statements is the same whether it is an Operating or Finance lease. The amortization of the Right of Use Asset and Lease liability would remain the same for either classification. The difference is that Operating leases expense rent on a straight line over the lease term. Still, the Finance leases recognize interest expense and depreciation.
Ratio and Covenants can also be affected by ASC 842 to include current ratio, debt to tangible net worth ratio, fixed charge ratio, and leverage ratio. The IRS is not changing its treatment of leases, so this accounting standard technically does not affect taxes. However, any book change would be a difference in the taxes.
What to do next?
Even though this standard was issued in 2016, the FASB is constantly updating the standard for more clarity and options. There have been over ten updates to ASC 842, and exposure drafts are currently in the process for additional changes. As we navigate through the implementation of this standard, it is going to take significant time and analysis to implement this standard. And the rules will continue to change as more challenges and issues are identified from the repercussion of implementing this standard.
We can Help
If this new accounting standard applies to your business – and still needs to be implemented – you must look at it immediately.
If you have any questions or want our help implementing this new standard, please email us as soon as possible at ASC842lease@bgm-cpa.com. Our fees for implementation are $375 per lease in the initial year and $200 for every renewal. These fees will significantly increase during our tax season (January through April 2023).