On November 10, 2021, the FASB’s Board of Directors voted unanimously to deny a request for a two-year extension to the effective date of the new lease accounting standard. Adoption requirements for private businesses and non-profit organizations are now imminent and will not be subject to further extensions.
In February 2016, Update of accounting standards n° 2016-03, Leases (Subject 842) was released to improve financial reporting for leasing transactions. After numerous extensions, the guidelines will now be in effect for fiscal years beginning after December 15, 2021 for private entities. Thus, for calendar year entities, the guidance will come into effect on January 1, 2022. A significant impact of the guidance is that the rights and obligations associated with most leases will now be recognized on the balance sheet with a lease obligation and a right to use the asset. Below are some of the key concepts to understand in the new rental standard as you embark on implementation:
Identification of leases
Since, for the most part, all leases will be accounted for on the balance sheet under ASC 842, the primary determination of how to account for the arrangement will be based on determining whether a contract contains a lease. The new lease accounting standard updated the definition of a lease as “a contract, or part of a contract, that conveys the right to control the use of an identified tangible capital asset ( an identified asset) for a period of time exchange for consideration”.
It will be important for entities implementing the guidance to understand both when an identified asset exists and when the entity is considered to control the use of the asset under the accounting guidance.
Click here for our article on identifying leases.
Short-term rental exemption
Entities will have the option to make an accounting policy choice not to recognize lease assets and lease liabilities for a lease with a term of 12 months or less. Entities should continue to track expenses associated with these agreements, as expenses associated with short-term leases will be subject to disclosure.
A contract may contain multiple components and in some cases one component of the contract may meet the definition of a rental component while another may be a service component. For example, a real estate lease in which the contract includes both the maintenance of the common areas (non-rental component) and the commercial space (rental component). Under the new lease guidance, an entity is required to separate these components and account for each component separately. The guidance allows lessees to choose which accounting policy to treat the two components of the contract as a single lease component. As a result, the lessee would recognize additional assets and liabilities.
Two-model lease classification approach
The new guidance retains the existing two-model approach to accounting for leases either as operating leases or as finance leases (formerly capital leases). However, the determination of the lease classification will now primarily affect expense recognition patterns and cash flow presentations and not the determination of whether the lease should be included on the balance sheet.
Recognition and measurement of lease assets and liabilities
The lease liability would initially be measured at the present value of future lease payments at the start of the lease. In determining which payments under the lease would be considered and when the liability should be recognized, tenants will need to pay particular attention to the following areas:
- Determination of the start date and duration of the lease
- Determining the appropriate treatment of variable and other payments included as part of the lease agreement
- Correct identification of an applicable discount rate
The lessee would also recognize a right-of-use asset based initially on the measurement of the lease liability, plus any lease payments made before the lease start date or initial direct costs incurred less any lease inducements received.
Entities are required to apply a modified retrospective transition approach using one of two acceptable methods:
- The entity presents comparative periods in accordance with the new accounting guidance in ASC 842 and recognizes any necessary adjustments associated with the implementation of the guidance at the beginning of the earliest period presented.
- The entity presents comparative periods in accordance with existing accounting guidance in ASC 840 and recognizes any necessary adjustments associated with the implementation of new guidance in ASC 842 at the beginning of the period in which the guidance is in effect.
In addition, entities have the option of choosing the following optional transitional practical expedients to facilitate the implementation of the new directives:
- A package of three transitory expedients, to be elected as a package, which includes:
- Do not reassess if a contract contains a lease
- No reassessment of lease classification
- No reassessment of initial direct costs
- An entity may use hindsight to determine the lease term and assess the impairment of a right-of-use
- An entity may choose not to apply the lease standard to existing or expired land easements that have not been accounted for as leases under existing lease guidance (Topic 840).
A caveat to using these practical expedients is that any error counted under ASC 840 would continue to be counted as an error under ASC 842.
Lessor accounting remains substantially unchanged with targeted improvement primarily to align lessor accounting with updated revenue recognition guidance.
You want to know more ?
This article highlights some of the key concepts to consider. In future articles, we will discuss key aspects of the guidance in more detail and provide practical advice on implementation issues. In the meantime, please contact your Clark Nuber or Joseph Purvis service team if you would like to discuss the impact of these changes on your organization’s financial reporting.
© Clark Nuber PS, 2021. All rights reserved.