Lease Accounting FAQs

Lease Accounting FAQs

by Tom Brunton
March 09, 2021

In 2016 the Financial Accounting Standards Board (FASB) issued ASU 2016-02, Leases (ASC 842). This guidance, along with IFRS 16, Leases, was a joint effort by the FASB and the International Accounting Standards Board (IASB) to improve financial reporting by requiring companies to recognize lease assets and lease liabilities on their balance sheet — a significant change. We’ve compiled these FAQs to help business leaders better understand the lease accounting regulations and achieve compliance.

Is there a minimum lease value or are all leases subject to the new standard?

Sadly, there is no materiality level for the new standard. So technically, even your $10/month ice machine lease should be included in your portfolio. This differs from IFRS 16, which has a low-value expedient that excludes leases at, or under, $5K.

When is ASC 842 effective?

For private companies, the standard becomes effective in 2022. Public companies have been operating under ASC 842 since 2019.

I heard that they’re getting rid of operating leases with ASC 842 — is that true?

No, there will still be two different classifications of leases under ASU 2016-02. The big difference is that operating leases will now be on the balance sheet.

What is a right-of-use (ROU) asset and how do I calculate it?

Under ASC 842, the ROU asset calculation starts with the initial amount of the lease liability plus any lease payments made before lease commencement. You add initial direct costs (IDC) and subtract any lease incentives received from the lessor (for example, tenant improvement allowances). This is an identical calculation for both operating and finance leases. These ROU assets show up under long-term assets separately broken out from fixed assets.

Is there a way to know I’ve calculated the ROU asset and lease liability properly when I adopt?

Assuming all of your accounting for ASC 840 is correct, the ending deferred rent balance should be the difference between the other two pieces of the puzzle. Deferred rent comes off the balance sheet as part of the transition and should, at the very least, approximate the difference between the calculated ROU asset and lease liability.

How will I determine the classification of leases under ASC 842?

Under ASC 840 there were always the four tests that you would run to evaluate the operating vs. capital lease classification. Like ASC 606 providing a little more room for management judgement, the FASB removed the FAS 13 “bright lines” test for ASU 2016-02. You can still use these tests as a good initial indicator as to whether the lease is an operating or finance (formerly capital) lease:

  • Is ownership of the leased property going to be transferred to the lessee at the end of the lease?
  • Does the lease have a bargain purchase option?
  • Is the lease term, at inception, equal to 75% or more of the estimated economic life of the leased property?
  • Is the present value of the minimum lease payments at the beginning of the lease 90% or more of the fair market value at the inception of the lease?

A yes to any of the four questions above would make it a capital lease under ASC 840 and would be an indicator it would be a finance lease under ASC 842.

I don’t have any building or auto leases, only some computer equipment and copiers. Do I still need to worry about the new standard?

Absolutely! All lease agreements need to be recorded under the new guidance. As part of ASU 2016-02, there is a requirement to examine service agreements for embedded leases. These exist where there is a dedicated piece of equipment (or other asset) used to satisfy the terms of the service contract. Examples might include printers and servers. Key factors to assess include whether there is an identified asset and whether there is right to control the asset during the agreement.

What is an incremental borrowing rate (IBR) and how do I know what mine is?

ASC 842 defines the IBR as “the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.” The IBR is used to discount the stream of lease payments to the net present value for purposes of calculating the right-of-use (ROU) asset and lease liability.

For private companies, if there isn’t a stated rate in the lease (there often isn’t), it allows an expedient for a risk-free rate. But in the current environment, the risk-free rate is low, which leads to a larger amount being on the balance sheet (due to the lower discount rate). Many companies are looking for practical alternatives to the risk-free rate so that the present value of payments is lower.

Is this going to impact my financial statement disclosures? I just changed them for ASC 606!

Under ASC 840, lease disclosures were very skinny and didn’t provide the user of the financials with much information about the nature, risks or judgements that were made by management. The new standard increases the level of disclosures. Management must disclose information about their leases that’s both qualitative and quantitative, as well as explanations about the assumptions used in the process.

Can we just use Excel for ASC 842? That’s what we do for Deferred Rent schedules under ASC 840.

You can, but it may not be efficient or the best solution for your company depending on your lease portfolio. This is likely manageable on a lease portfolio of less than 20 leases, but there are many perks to leveraging a platform to maintain and report your lease balances. As your lease portfolio swells, so will the effort to keep it in check and ensure accuracy. Keep in mind that there is increased focus on things like spreadsheet controls from auditors. While you may save a little money on skipping a software platform, it may backfire when the audit team crawls through your Excel workbook to validate and corroborate the mechanics used.

If I’m a private company looking to take part in a SPAC, do I need to worry about ASC 842 yet?

Without a doubt. If you have serious aspirations about becoming a public company — through a traditional IPO or a special-purpose acquisition company (SPAC) — the clock is ticking to get this done. When you are on the other side of the effort, you’ll be expected to act like a public company, and this guidance went into effect for them in 2019.

What is the difference between IFRS 16 and ASC 842?

There are a few, but some of the major differences include the classification criteria for leases. IFRS 16, governed by the IASB, doesn’t offer two classification types – unless exempt, all leases are classified as finance Leases. Which brings us to the next difference – materiality exemptions. Under IFRS 16, you do not have to include “low value assets” ($5K or less). The IASB also includes an out, like the FASB, for short-term leases. Those two, along with things like transition requirements, treatment of variable payments tied to an index, and practical expedients available to companies are the major differences between the standards.

Should my bank understand the changes and how this impacts my debt covenants, and will they automatically adjust for this?

Most debt agreements include clauses that freeze (or semi-freeze) U.S. GAAP at the time of the financing. So technically, you may be fine. Nevertheless, your balance sheet is going to change dramatically as a result of the adoption. Given that public companies adopted ASU 2016-02 in 2019, lenders are aware of the new standard and likely can provide an amendment to adjust your covenants. This will prevent having to recast or modify financial statements for purposes of covenant compliance.

My parent company in the U.K. has already adopted but we have not in the U.S. – what do I do now?

It’s time to impress the parents and get your leases cleaned up and on the balance sheet. This will help provide greater visibility to the parent company by removing what is effectively off-balance-sheet financing (through operating leases). Like Thanksgiving political discussions with the family, this gets all of it on the table.

Which industries are most impacted?

Any company can be impacted heavily by this if they have a significant lease portfolio. Industries that are heavy on equipment or real estate, such as retail, telecommunications, healthcare or manufacturing may find that they have a bigger lift. Under ASC 840, airlines didn’t even always have their aircraft leases on the balance sheet, so clearly this is a significant shift for them. Many companies went through the buy vs. lease analysis several years ago, so that decision may have real ramifications on the adoption now.

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