On November 10, 2021, the FASB board voted unanimously to reject a request for a two-year extension to the effective date of the new lease accounting standard. Private companies and not-for-profit organization adoption requirements are now imminent and will not be subject to any further extensions.
In February 2016, Accounting Standards Update No. 2016-02, Leases (Topic 842) was issued with the intent to improve financial reporting for leasing transactions. After numerous extensions, the guidance will now be effective for fiscal years beginning after December 15, 2021 for private entities. Thus, for calendar year entities, the guidance will be effective January 1, 2022. A significant impact of the guidance is that the rights and obligations associated with most leasing arrangements will now be recognized on the balance sheet with a lease obligation and right-of-use asset. Below are some of the key concepts to understand in the new leasing standard, as you embark on implementation:
Identification of Leases
Since, for the most part, all leases will be recognized on the balance sheet under ASC 842, the key determination for how to account for the agreement will be based upon the determination if a contract contains a lease. The new lease accounting standard updated the definition of a lease to be “a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in 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.
Short-Term Lease Exemption
Entities will have the ability to make an accounting policy election to not recognize lease assets and liabilities for a lease with a term of 12 months or less. Entities should continue to track expenses associated with these agreements, since expenses associated with short-term leases will be subject to disclosure.
A contract may contain multiple components, and, in certain instances, one contract component may meet the definition of a leasing component while another may be a service component. For example, a real estate lease in which the contract includes both common area maintenance (non-lease component) and retail space (lease component). Under the new leasing guidance an entity is required to separate these components and account for each component separately. The guidance does allow for lessees to make accounting policy election to treat both 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 for accounting for leases as either operating leases or financing leases (formerly, capital leases). However, the determination of the lease classification will now primarily affect the expense recognition patterns and cash flow presentations and not the determination on if the lease is included on the balance sheet.
Recognition and Measuring Lease Assets and Liabilities
The lease liability would be initially measured at the present value of the future lease payments at lease commencement. To determine what payments under the leasing arrangement would be considered and when the liability would need to be recognized, lessees will need to give specific consideration to the following areas:
- Determination of lease commencement date and lease term
- Determination of proper treatment of variable and other payments included as part of the lease
- Proper identification of an applicable discount rate
The lessee would also recognize a right of use asset based initially upon the measurement of the lease liability, plus any lease payments made before the lease commencement date or initial direct costs incurred less any lease incentives received.
Entities are required to apply a modified retrospective transition approach under one of two acceptable methods:
- Entity presents comparative periods in accordance with the new accounting guidance in ASC 842 and recognizes any adjustment necessary associated with implementation of the guidance at the beginning of the earliest period presented.
- Entity presents comparative periods in accordance with existing accounting guidance in ASC 840 and recognizes any adjustment necessary associated with implementation of the new ASC 842 guidance at beginning of the period the guidance is effective.
Further, entities have the option to elect the following optional transitional practical expedients to aid in the implementation of the new guidance:
- A package of three transitional expedients, which must be elected as a package, that includes:
- To not reassess whether a contract contains a lease
- No reassessment of lease classification
- No reassessment of initial direct costs
- An entity may use hindsight when determining lease term and assessing impairment of a right of use asset
- An entity may choose to not apply the leases standard to existing or expired land easements that were not accounted for as leases under existing lease guidance (Topic 840).
One caveat to utilizing these practical expedients is that any error that was made accounting under ASC 840 would continue to be considered an error under ASC 842.
Lessor accounting remains substantially unchanged with targeted improvement primarily to align lessor accounting with updated revenue recognition guidance.
Want to Learn 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 guidance on implementation issues. In the meantime, please contact your Clark Nuber service team or Joseph Purvis if you would like to discuss how these changes will impact your organizations financial reporting.
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