In February of 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Codification (ASC) Topic 842 (ASC 842), which requires companies to bring all leases onto their balance sheet. The new standard was adopted by certain public registrants in 2019 and is now required to be adopted by all public Emerging Growth Companies (EGCs) and non-public companies in the 2022 financial statements. The process of identifying all leases, analyzing terms, calculating transition adjustments and preparing to record leases on your balance sheet can be complex and time-intensive. Companies that have not yet started their adoption procedures should begin immediately to ensure that their 2022 financial statements are issued in a timely manner.
A recap of the new standard’s evolution
Many users of financial statements have made adjustments to bring operating leases onto companies’ balance sheets. However, the true genesis of the FASB’s lease accounting project traces all the way back to a 2005 report authored by the U.S. Securities and Exchange Commission on arrangements with off-balance sheet implications that was mandated by the Sarbanes-Oxley Act of 2002.
In March of 2009, the FASB and the International Accounting Standards Board (IASB) published a joint “Discussion Paper, Leases: Preliminary Views.” The Boards followed up with their initial joint exposure draft on a new lease accounting standard in August of 2010, which triggered almost 800 comment letters. The volume of comment letters necessitated six arduous years of deliberation, roundtables, re-exposure, comments, and re-deliberation until Accounting Standards Update No. 2016- 02, Leases (codified in ASC Topic 842) was released in February of 2016.
ASC 842 became effective for many public companies in 2019 (annual periods beginning after December 15, 2018, and interim periods therein). For private enterprises as well as public companies that are classified as EGCs who elect to follow private company adoption timelines for accounting standards, the implementation date for ASC 842 was originally planned for December 31, 2019. However, this effective date was delayed. Calendar year reporting companies that have not yet adopted ASC 842 are required to do so as of January 1, 2022 (annual periods beginning after December 15, 2021).
Implementing ASC 842 is complex and time-intensive
The process of implementing ASC 842 can reveal complexities, surprises, and considerations that require specialized expertise and potentially tedious calculations. For example, some SEC filers’ disclosures indicate ASC 842 implementation efforts required more than two years to completely and accurately document the implementation process and account for leases based on the new standard’s criteria.
The following approach outlines the key steps for implementing the new leasing standard.
Step 1 – Lease identification
First, you will need to identify all of your current lease arrangements, including traditional leases and those embedded in other arrangements, such as service contracts. If you lack a centralized contract repository, begin by reviewing expenses (by vendor) to identify any recurring obligations that might be subject to the new standard.
To determine whether or not a contract contains a lease, assess if there is an identified asset and if the contract includes the right to control the use of that asset for a period of time in exchange for consideration. If you conclude that a contractual obligation contains a lease, you will need to further analyze the lease terms to determine if it meets the new standard’s criteria.
Step 2 – Lease classification
Once you identify your lease obligations, you must determine the appropriate classification. ASC 842 provides for the following lease types:
When analyzing your lease obligations for potential changes under ASC 842, aggregate key contractual provisions that were not considered leases under ASC 840. Separate each contractual obligation into lease and non-lease components, with consideration allocated amongst the various components. Next, classify lease components as either operating or finance leases to determine the appropriate balance sheet presentation and expense recognition treatment. Focus areas should include extension options, discount rates, lease and non-lease components, and income tax considerations.
Step 3 – Recognition and measurement
The most significant change under ASC 842 is that lessees must recognize a lease liability and a right-of-use (ROU) asset for operating leases. A lease liability is measured as the present value of the remaining lease payments using a discount rate determined at inception. The ROU asset is equal to the lease liability balance, adjusted for certain other items, including lease incentives and similar provisions that may cause uneven payments.
The new standard requires enhanced disclosures so financial statement users can better understand the amount, timing, and uncertainty of cash flows arising from leases. That means both lessees and lessors will need to provide qualitative and quantitative information to accurately outline significant judgments and estimates inherent in applying the new standard.
Step 4 – Ongoing considerations
In addition to classifying leases at the beginning of an arrangement, you must also reassess leases throughout the life of the arrangement, especially if the lease is modified in any way. Even if the lease is not modified, there are scenarios where a lessee could be required to re-measure lease payments.
For example, under ASC 842, lessees must reassess the lease term if their expectations change related to options to renew, terminate, or purchase the underlying asset. The long-lived lease ROU asset resulting from the adoption of the standard will also be subject to impairment testing along with your other long-lived assets. You should add controls to your monthly close to ensure that these ongoing considerations are being addressed in a timely manner throughout the year.
Throughout implementation, continue to evaluate the effect of ASC 842 on your accounting policies, procedures, controls, and systems. You may discover that ASC 842 creates a need for more sophisticated accounting software to address its requirements. By looking at the requirements as the start of more sweeping improvements, the process becomes a great opportunity to evaluate and enhance your procurement processes and centralize contracts. Both can generate cost savings and introduce additional efficiencies over time.
We are ASC 842 experts
WilliamsMarston has led the adoption of ASC 842 for numerous companies ranging from early-stage to large multinational public corporations in a variety of industries. Whether it’s the embedded lease search or establishing the incremental borrowing rate (IBR), our team of experts will ensure that your ASC 842 adoption goes smoothly and you are fully prepared for year-end reporting. Please contact one of our accounting or valuation leaders for more information on how WilliamsMarston can assist your company with the adoption of ASC 842:
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