The Financial Accounting Standards Board (FASB) replaced the old lease accounting standard (ASC 840) with ASC 842 to increase transparency of entity lease obligations so that business stakeholders can more clearly see the company’s obligations and financial position.
What does this mean to you?
Review your debt covenants! Under the new standard, leased assets will now affect the liabilities on your balance sheet and thus could put you in jeopardy of violating your company’s compliance with its debt covenants and key ratios.
Private companies with a December 31, 2022 year end will be affected. Under ASC 842, almost all leases (with terms greater than 12 months) will be recognized on the balance sheet as right-of-use (ROU) assets with corresponding lease liabilities. This is significantly different compared to how ASC 840 required operating leases to be left off the balance sheet since the entity did not own the asset—the leasing company did. When considering the dollar amounts of commonly leased assets such as large machinery and equipment and commercial property, as well as the lengthy terms, private company balance sheets will change substantially with the new standard.
The first step is to determine which of your contracts or business arrangements qualify as a lease. ASC 842 states a lease exists if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration.
Below are other key takeaways of ASC 842 Leases.
- ASC 842 requires leases to be classified (with terms greater than 12 months) on the balance sheet as either – 1) financial lease (previously capital leases under ASC 840), in which control over the identified asset is transferred (and is a sales-type lease for the lessor) and 2) operating lease, in which control over only the use of the identified asset is permitted.
- Note, the treatment for financial leases under ASC 842 remains the same as the accounting for capital leases under ASC 840.
- For operating leases, the right-of-use-asset is valued as the initial amount of the lease liability plus any initial direct costs and payments made prior to the commencement date, minus lease incentives and the lease liability is calculated as the present value of the lease payments, using the discount rate specified in the lease or the company’s incremental borrowing rate.
- Income statement affect remains relatively the same, however the lease costs are recorded as straight-line amortization expenses plus interest expenses.
Some leases are excluded from the new standard including leases of intangible assets, leases to explore for or use mineral, oil, natural gas, and similar non-regenerative resources, leases of biological assets, including timber, leases of inventory, and leases of assets under construction.
We are here to help!
At ATKG, we can help you determine what does and does not qualify as a lease and help you implement ASC 842. We are happy to explain the financial statement effect and disclosure changes required by ASC 842 to your banker. Please give us a call to get started on your 842 implementation.