Lease debt and right-of-use assets will appear on December 31, 2022, financial statements. All leases with a term of more than one year will appear on your balance sheet, even those with related parties.
This article focuses on the lessee’s perspective.
The Financial Accounting Standards Board (FASB) issued ASC 842, Leases, which governs lease accounting for nongovernmental entities. Therefore, financial statements created following generally accepted accounting principles (GAAP) are subject to ASC 842.
Why This Matters
New lease debt can create compliance issues if you have debt covenants.
Additionally, you want to be in the know about lease accounting.
If you’re a CFO, you’ll get questions from your board.
If you’re an owner, you want to understand why new debt and assets appear on your balance sheet.
If you’re an investor, understand the accounting impact on the companies you invest in.
If you’re a lender, you want to know how leases impact your customers.
The impact on a lessee’s income statement will generally be minimal.
The way a lessee accounts for operating lease (defined below) expenses under the new standard is much the same as before—straight-line over the lease term.
Financing lease (defined below) expenses will appear as amortization of the right-of-use asset and interest expense.
The principal portion of the payments will reduce the lease debt.
The noticeable change occurs in the balance sheet.
Companies will record a right-of-use asset (an intangible) and a lease obligation. The asset and debt will largely offset each other, and the company will record each upon the commencement of the lease.
Previously, companies recorded a leased asset (e.g., motor grader) and the lease debt for capital leases (now called financing leases). But entities did not record an asset or liability for operating leases (those leases that were not capital leases).
Using ASC 842, companies now book a right-of-use asset and lease liability for all leases with a term of more than one year (including operating leases).
If you want to know more, read on (or give us a call).
Why the Change in Lease Accounting
A balance sheet should reflect all assets controlled by a company. (FASB’s Conceptual Statements include this logic.)
For example, if a company leases a car for three years and can drive anywhere it desires, it controls the asset. Therefore, the company reflects the vehicle on its balance sheet.
And, of course, the related debt (lease obligation) is also shown on the balance sheet.
What is a lease?
A lease is a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment for a period of time in exchange for consideration.
So, the asset has to be identifiable. A contract for 3% of a building is not identifiable. An agreement for the third floor of a building is identifiable.
The lessee must also control the asset.
The Difference between Financing Leases and Operating Leases
ASC 842 addresses two types of leases: financing leases and operating leases.
Financing leases tend to be longer term than operating leases. For example, a lease of a crane for fifteen years and the crane’s economic life is eighteen years.
Operating leases are shorter term—for example, a two-year lease of a new car.
ASC 842 says that operating leases are those that are not financing leases.
A lease is a financing lease when:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset (e.g., a lease for 75% of the asset’s economic life).
- The present value of the sum of the lease payments and residual value guarantee equals or exceeds substantially all of the fair value of the underlying asset (e.g., the present value of payments exceeds 90% of the fair value of the asset).
- The underlying 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.
All other leases are operating leases.
Determining the Lease Obligation
The company records the lease obligation as the present value of future lease payments.
Use a discount rate to compute the amount, usually risk-free (i.e., treasury rate) or incremental borrowing rate.
The term of the lease includes the following:
- Noncancellable period
- Option to extend the lease if the lessee is reasonably certain to exercise that option
- Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
- Periods covered by an option to extend (or not to terminate) the lease in which the lessor controls the exercise of the option
Reasonably certain = Economically compelled
For example, if a company has significant leasehold improvements, it may feel compelled to remain in a building during the period of the renewal option.
Determining the Right-of-Use Asset
The right-of-use asset includes the lease obligation plus the following:
- Any lease payments made to the lessor at or before the commencement date minus any lease incentives received plus
- Any initial direct costs incurred by the lessee
Often the right-of-use asset will equal the lease obligation.
Subsequent Accounting After Recording the ROU Asset and Lease Liability
Amortize the ROU asset over the life of the lease. In other words, expense a portion of the asset in each period.
Reduce the lease liability based on the lease amortization, much as you do with any debt. Recognize lease interest in the income statement and reduce the obligation by the principal paid. (Operating lease expense includes interest and amortization of the ROU asset. Financing lease expenses appear separately in the income statement as interest and ROU amortization.)
Companies can omit leases of one year or less from the balance sheet. FASB provides an election for this purpose. Disclose this election if used.
Implementation of ASC 842
ASC 842 requires the modified retrospective method to restate comparative periods in financial statements. In other words, companies restate the prior periods as though ASC 842 was in use.
Restate the financial statements on the first day of the earliest period presented.
Companies can exercise a practical expedient not to restate the prior periods. Disclose this election if used. In other words, the current year will reflect ASC 842, and the previous periods will not.
Call Us If You Need Help
ASC 842, Leases, is one of the most complex accounting standards ever. Please call us if you need any assistance.
We can also create lease amortizations for you.