Be Prepared: Now is the Time to Start Planning for the New Lease Standard
In February 2016, the Federal Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02, Leases (Topic 842), which amends the existing lease accounting standards and replaces Topic 840. For years, the users of financial statements have had concerns with the accounting and disclosure requirements prescribed by Topic 840, principally for lessee accounting of operating leases. Topic 840 allows off-balance sheet accounting for the assets and commitments associated with lessee operating leases, which makes it difficult for lenders, shareholders, and investors to obtain a true picture of a company’s financial well-being. The new guidance requires that nearly all leases are recorded on the balance sheet to address these concerns.
In response to the adverse impacts the COVID-19 pandemic was having on the global economy, FASB issued ASU 2020-05, Revenue from Contracts with Customers (Topic 606) and Leases (Topic 842): Effective Dates for Certain Entities to provide relief to private companies by deferring the effective date of Topic 842 to fiscal years beginning after December 15, 2021 and interim periods within fiscal years beginning after December 15, 2022. Topic 842 is adopted by using a modified retrospective transition approach either as of 1) the earliest comparative period by recording the cumulate adjustment to the opening balance of retained earnings (if any) in the earliest period presented or 2) the effective date of adoption with a cumulative adjustment to opening balance of retained earnings (if any) in the period of adoption.
Accountants have been reading about the new lease standard for a while now and have likely attended several trainings on the topic; however, many companies that have adopted the new standard, or are in the midst of adoption, have shared they underestimated the efforts required in adopting Topic 842. As a result, inefficiencies in both time and cost were incurred that were likely avoidable. These companies would suggest that if a company has not started to plan for the adoption of Topic 842, it is strongly recommended to start preparing now for fear of quickly realizing you are behind. Adoption can have a significant impact on financial statements, accounting policies and procedures, and internal controls.
Key Differences Between Topic 840 and Topic 842 for Lessees
Definition of a Lease
Topic 842 provides for a much broader definition of a lease, defined as a contract, or part of a contract, that conveys the right to control the use of an identified asset for a period of time in exchange for consideration. This definition differs from the definition under Topic 840, which defined a lease as an agreement conveying the right to use property, plant, or equipment for a stated period of time. Accordingly, contracts that historically were not accounted for as leases may be considered leases under the new standard. When assessing whether or not a contract is, or contains, a lease it is important to distinguish if the contract contains an identified asset and whether the lessee obtains control of the identified asset. An identified asset might be explicitly stated in a contract, such as a serial number for a piece of equipment or a specific floor of an office building or it might also be implied, provided that a supplier does not have substantive substitution rights. The definition of substantive substitution rights changed under Topic 842 and exists when a supplier has the practical ability to substitute alternative assets during the period of use and the supplier would benefit economically by exercising their substitution right. A company controls an identified asset when it has the right to obtain substantially all of the economic benefits from its use and has the right to direct its use.
Topic 842 requires that lease classification be determined at lease commencement, compared to lease inception previously required by Topic 840. Topic 842 also amends the well-known terminology of capital lease to finance lease. Under Topic 842, if any of the following criteria are met, the lease is to be accounted for as a finance lease:
- Transfer of ownership
- Purchase option that the lessee is reasonably certain to exercise
- Lease term is for a major part of the remaining economic life of the asset
- Present value of minimum lease payments equals or exceeds substantially all of the fair value of the asset
- Asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term
These criteria are generally the same criteria to classify a lease as a capital lease under Topic 840 with a few changes. Topic 842 removes the bright-line thresholds, including a lease term greater than or equal to 75% of the useful life of the asset and a present value of minimum lease payments greater than or equal to 90% of the fair value of the leased property. However, FASB has clarified that a reasonable approach to assess these criteria under Topic 842 would be to continue to use the same thresholds prescribed by Topic 840. Topic 842 also introduces a fifth criteria related to assets that have no alternative use, which may result in a lease being classified as a finance lease that would have been classified as an operating lease under Topic 840.
Under Topic 842, the lease term includes the non-cancellable period for which a lessee has the right to use an underlying asset, together with: 1) periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option, 2) periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option, and 3) periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor. It is important to understand that “reasonably certain” is a high threshold and management will have to apply judgment in determining the appropriate lease term. Management should document their assessment and conclusion, weighing factors relevant to the contract, underlying asset, market, and entity itself.
Similar to Topic 840, under Topic 842 the discount rate to be used when measuring the present value of lease payments is the rate implicit in the lease, if known, or the incremental borrowing rate. However, the new standard significantly changed the definition of an incremental borrowing rate to the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar lease term an amount equal to the lease payments in a similar economic environment. While the definition of incremental borrowing rate changed under Topic 842, we expect many financial institutions will continue to look to Federal Home Loan Bank advance rates for a term commensurate with the lease term. FASB recognizes that the new definition of the incremental borrowing rate may be a challenge for companies and allows for private companies to make an accounting policy election to use a risk-free discount rate for a period consistent to the lease term.
Balance Sheet Recognition of Operating Leases
The most notable change between Topic 840 and Topic 842 is that operating leases will be reflected on the balance sheet through the measurement of a lease liability and right-of-use asset. The lease liability is initially measured as the present value of the lease payments not yet paid, discounted using the discount rate for the lease at lease commencement. The right-of-use asset is initially measured as the lease liability plus any lease prepayments and initial direct costs, less any lease incentives received. A lessee can make an accounting policy election not to record leases with terms of 12 months or less on the balance sheet.
Qualitative and quantitative disclosure requirements have substantially increased under Topic 842. Companies should be prepared to have a thorough understanding of their lease arrangements as well as a comprehensive understanding of the new standard to meet the expanded disclosure requirements.
How to Prepare for Adoption
Preparation and planning will be essential to effectively and efficiently adopt the new standard. It is important to identify a complete population of leases, organize the executed contracts, and extract and analyze key elements of the agreements. Significant judgments and estimates made by a company’s management should be well documented. Policies, procedures, and controls should be established for initial and subsequent measurement of the lease liability and right-of-use asset, as well as, developing the required disclosures. Companies with large portfolios of leases may choose to implement a software to assist in the accounting and disclosure requirements of Topic 842 and should assess the various software options on the market to determine which one best suits their business needs. Other companies may choose to manually track their lease portfolio.
It is important to also consider the indirect impacts of adopting Topic 842. The lease liability, right-of-use asset, lease cost (operating lease), amortization and interest expense (finance lease), and any cumulative-effect adjustment resulting from the change in accounting principle should be appropriately reported in call reports. Additionally, regulatory capital ratios may be impacted. While FASB did not provide guidance about whether right-of-use assets represent a tangible or intangible asset, the Basel Committee on Banking Supervision and the Federal Financial Institutions Examination Council have clarified that if the underlying asset being leased is a tangible asset, the right-of-use asset should not be deducted from regulatory capital and should be included in the risk-based capital and leverage denominators, with the right-of-use asset being risk-weighted at 100%. Furthermore, loan customers may be in violation of covenants that impose limits on overall debt balances and include debt-related financial ratios if they have a significant lease liability related to operating leases after adoption. The loan covenants may need to be modified to prevent unnecessary covenant failures as a result of adoption. The adoption of Topic 842 may also impact a company’s accounting for its deferred taxes.
While a 2022 financial statement audit may seem like something in the distant future, companies need to invest the time now to consider the impact of adoption of Topic 842. Aspects of the new guidance can be complex and will take time and effort. If you haven’t already done so, we encourage you to connect with your Baker Newman Noyes advisor soon to begin this discussion.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.