Steven J. Cohen Principal, CPA, CGFM
10 Feburary 2022
Beginning for financial statements with fiscal years beginning after December 15, 2021, the Financial Accounting Standards Board (FASB) will require private for-profit and not-for profit entities to implement the new lease standard (known as Accounting Standards Codification Topic 842, Leases). This translates to the year ending June 30, 2023, for June year ends and December 31, 2022 for calendar year ends.
Prior to the implementation of the new lease standard, capital leases are capitalized on the balance sheet, while operating leases are not capitalized on the balance sheet, but rather disclosed in the notes to the financial statements. Many users of financial statements believed that not having operating leases capitalized on the balance sheet makes financial statement analysis more difficult.
It is in response to the concerns of those users of the financial statements that the new lease standard was established. The purpose of the new lease standard is to increase the transparency and the comparability of financial information by recognizing virtually all leases on the balance sheet.
Definition of Lease
Under the new lease standard, the definition of a lease is “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.”
FASB defines control of a leased asset when both of the following occurs:
- The right to obtain substantially all of the economic benefit from the use of the identified asset
- The right to direct the use of the identified asset
An entity shall apply lease accounting for arrangements that meet the above definition unless it is subject to one of the following exceptions:
- Leases of intangible assets, minerals, oil, natural gas, biological assets, timber, inventory, and assets under construction.
- Short-term leases – a lease term of 12 months or less that does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- A reasonable capitalization threshold – similar to fixed assets, management can determine that recognizing the lease would not be material to the entity’s financial statements.
Why it is important?
- Implementing the new lease standard properly will be important to earn a clean audit opinion under generally accepted accounting principles.
- The change to lease accounting can affect key financial ratios, such as the current ratio and debt service coverage ratio. These ratios could be tied to loan covenants.
Financing vs. Operating Leases
The new lease standard creates two different types of leases: financing leases and operating leases.
Financing leases – to be considered a financing lease, at least one criterion must be met at the lease commencement date:
- The leased asset is transferred to the lessee on or before the end of the lease term
- The lessee has an option to purchase the leased asset and it is reasonably certain that the option will be exercised
- The lease term is for the major part of the remaining economic life of the underlying asset
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the leased asset
- The leased asset is of such a specialized nature that there is no alternative use to the lessor after the lease is completed
Operating leases – an operating lease is any lease that is not a financing lease.
Lessees will recognize a right of use (ROU) asset and a corresponding lease liability. The liability will initially be measured at the present value of the remaining lease payments (including the exercise price of an option to purchase the leased asset if it reasonably certain for this event to occur) using a proper discount rate. The discount rate should be the rate implicit in the lease arrangement. If the discount rate is not known, the entity can use their incremental borrowing rate or the risk-free rate.
The initial ROU asset is based upon the lease liability, lease payments made to the lessor before the lease’s commencement date, direct costs that the lessee incurred, and lease incentives made by the lessor.
The initial accounting for lessors is more complicated.
If the lease is operating, the entity will continue to report the leased asset. Lease income will generally be recognized over the lease term.
If the lease is financing, the entity will de-recognize the leased asset and report the net investment in the lease. The corresponding credit will be recognizing a portion to interest income and an implied selling profit that will either be recognized immediately or over the lease depending on several factors.
- Assign a team leader to be responsible for implementation
- The leader should define the issues related to implementation, resources needed to complete the lease review, and timeline for completion
- Determine capitalization thresholds
- Consideration of quantitative and non-quantitative factors
- Should be evaluated on the gross lease asset and liability rather than the net of those two figures
- Identification of possible leases
- Discussion with personnel from other departments
- Review of frequent disbursements to the same vendor as this may indicate a lease
- Document your lease conclusions for each arrangement:
- Why the arrangement is or is not a lease
- Key variables in the lease determination such as lease term, payments, discount rate, incentives, renewals and option to purchase the asset
- Discussion with your financial institutions since lease implementation could have an impact on debt covenants
- Calculation of needed information
- Purchase of lease software
- Excel spreadsheet
- CPA assistance for the calculation
This discussion is a summary of a very difficult standard to implement. Please contact your O’Connor & Drew representative or myself for additional guidance.
By Steven J. Cohen, CPA, CGFM