How to Correctly Implement the Updated Lease Standard (ASC 842)

October 25, 2020
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The impact of the latest ASC 842 lease standard is far reaching and substantially changes the way leases are recorded. Here are some answers to common questions regarding how your organization should implement the standards accurately.

What Does the Updated ASC 842 Lease Accounting Standard Entail?
FASB’s latest lease standard introduces major changes in financial reporting of lease arrangements. Known as ASU No. 2016-02, Leases, this accounting standard directly impacts lessees, as significantly more leasing arrangements will need to be reported on the balance sheets of lessees.

Legal Definition of a Lease — A lease has been defined as “a contract, or part of a contract, that conveys the right to control the use of an identified asset (the underlying asset) for a period of time in exchange for consideration.” The following two criteria are required to be met to conclude that a contract contains a lease:

  • The use of an identified asset is either explicitly or implicitly specified. A contract does not involve the use of an identified asset if a supplier or lessor, has the substantive right to substitute the asset used to fulfill the contract.
  • The customer controls the use of the identified asset; i.e., the lessee has the right to direct the use of the identified asset and obtain substantially all of the benefits of doing so throughout the period of use.

When Did the Updated Lease Standard Become Effective?
While this lease standard was effective for fiscal years beginning after December 15, 2018, for public business entities and an employee benefit plan that files or furnishes financial statements with or to the U.S. Securities and Exchange Commission, other entities have been provided relief on the effective dates. For other entities, the effective dates are as follows, including the most recent delays issued FASB:

  • A nonprofit entity that has issued or is a conduit bond obligor for securities that are traded, listed, or quoted on an exchange or an over-the-counter market that has not yet issued financial statements or made financial statements available for issuance as of June 3, 2020, shall apply the lease standard for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years.
  • All other entities shall apply the lease standard for financial statements issued for fiscal years beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022.

What Do I Need to Know to Implement the Updated Lease Standard?
Here are some common terms that are important to understand when it comes to implementing ASC 842 requirements:

Dual Approach Accounting Model — The latest lease accounting standards provide for a dual approach for lessee accounting, with leases that transfer substantially all the risks and rewards incidental to ownership as finance leases, with remaining leases accounted for as operating leases. While the accounting for a finance lease will be very similar to that of a capital lease under current standards, accounting for the updated classified operating leases will undergo a major change, as those leases will also result in recognition of a right-of-use asset and a lease liability on the entity’s balance sheet.

The accounting for a finance lease will not represent a major change compared to the current financial accounting for a capital lease, with a lessee accounting for a right-of-use asset and a lease obligation at the commencement of a lease. The right-of use asset and related lease liability will generally be recognized at the present value of the future lease payments, with the asset being amortized over the term of the lease, while the lease obligation will be accounted for similar to debt, with lease payments being recognized as a reduction of the lease obligation, along with an interest component determined using an effective interest method.

The initial measurement of an operating lease will also result in the recognition of a right-to-use asset and a lease obligation. Similar to a finance lease, the right-to-use asset will be recognized at the present value of the lease payments; however, in subsequent periods the asset will be effectively “remeasured” using the original lease assumptions. The lease liability will be charged to operations as rent expense in a manner that should approximate straight-line lease expense in the absence of other events, such as an impairment loss related to the right-of-use asset.

Lease Classification — The classification of leases between finance and operating leases is somewhat similar to, but not as explicit, as current guidance used to classify leases between capital and operating leases. The primary lease classification criteria are:

  • Transfer of ownership of the underlying asset to the lessee
  • Option to purchase (reasonable certainty)
  • Lease term compared to the economic life of the asset
  • The present value of the minimum lease payments compared to the fair value of the underlying leased assets at lease inception
  • Specialized nature of the underlying asset—a lease of specialized assets can only be classified as a finance lease when the lessee can use the assets without major modifications.

Lease Term, Optional Renewal Periods and Purchase Options — In determining the lease term, an entity is required to consider all relevant factors that create an economic incentive to exercise an option to extend, or not to terminate, a lease. Consideration of optional renewal periods and purchase options included in lease arrangements will be evaluated based upon a “reasonably certain” threshold, considering such “economic incentives.” For example, if the exercise of a renewal period or purchase option is considered to be reasonably certain, the renewal period(s) or purchase options would be included in the determination of the classification and initial measurement of the lease. Lease terms will only be reassessed if a significant event or change in circumstances occurs that is within the control of the lessee.

Short-Term Leases — Leases with terms of 12 months or less will not be required to be recognized on the balance sheet, unless the lease contains one or more renewal options and the exercise of the renewal option(s) is reasonably certain.

Impairment Considerations — As leasing arrangements will now result in the recognition of an asset, entities will be required to evaluate the updated right-to-use assets in accordance with existing GAAP, by considering whether the undiscounted future cash flows associated with the asset are sufficient to recover the carrying amount of the asset. If not, an impairment charge will be recognized, consistent with current GAAP for long-lived assets.

Transition — The standard offers an option on how to transition, however both options require modified retrospective transition. The option is when to apply the standard either (1) to all comparative periods presented or (2) only to the current period. The updated lease accounting guidance will be applied to all capital and operating leases existing at either the beginning of (1) the earliest comparative period presented or (2) at the current period depending on the transition option selected. The transition does not require any transition accounting for leases that expired before the date of initial application of the standard. In plain English … existing leases included in financial statements presented for periods prior to the effective date will be required to be accounted for as right-of-use assets and corresponding liabilities, in accordance with the transition provisions of the standard unless the lease expired prior to the initial effective date.

Nonpublic Entity Alternatives — Other than allowing nonpublic business entities to use the risk-free rate as a discount rate in the determination of the present value of future lease payments, and a delayed effective date compared to that required for public business entities, FASB is not providing any specific relief or accounting alternatives for nonpublic entities.

Learn more about the updated leasing standard in our recent webinar.

How Can I Prepare for Implementation?
Here are some recommendations to ensure your organization remains in compliance with this ASC 842 lease update.

1. Prepare Complete Listing of Leases
The starting place for implementation is ensuring you have a complete listing of all known lease contracts for real estate property, plant and equipment. However, since leases can be in contracts that you would not expect to have leases, such as service contracts for storage space, long-term supply agreements, delivery services, and IT software contracts, you will also need to broaden your review to more than your organization’s current lease expense accounts.

The best place to start is to review all expense accounts and look for recurring payments, because these often have the potential to have contracts that contain a lease. Once you have a list of recurring payments, review the contracts for these payments to identify leases. If the contract meets the elements of a lease—a contract for an identified fixed asset that your organization controls the use over the contract period—your organization has a lease that should be added to your listing.

2. Determine Software Needs
Once you have identified and compiled all your organization’s leases, you will need to decide how to track leases going forward. There are numerous ways to track leases, including using a spreadsheet, using an additional module to your current software, or using new software separate from your current general ledger. Here are some factors to consider:

  • Amount of leasing activity – Are there only a few leases that are consistent each year or are there several new lease contracts every year?
  • General ledger software capabilities – Does your company’s current software have a module to calculate the journal entries for the leasing standard?
  • Process for identifying a new lease – Are signed contracts in your company routed to a central location or stored across several locations?
  • Location of the leased assets – Are they all in one location or dispersed across the organization or world?
  • Maintenance of lease contracts – Are contracts stored in a central location or at locations throughout your organization?
  • Lease renewals – How are managers notified when renewals are coming?

Software providers have developed solutions to these questions that could make the process more efficient for your organization. However, the most robust solution is not always the best solution, and there are always software and implementation costs to consider. Careful consideration of the current process and future needs are key to finding the correct solution.

3. Define Implementation Strategies
When implementing the updated lease standard, there are certain elections to consider. Depending on your organization’s specific situation, these elections could save you time in the implementation process.

First, consider what periods to apply the latest standard to. There are two options: All comparative periods presented or only for the period of adoption. The implementation of the standard will be very different depending on which of these two options you choose. Second, consider some of these other elections in your organization’s implementation:

  • Package of practical expedients for not reassessing contracts for leases, lease classification and initial direct costs.
  • Recording leases with terms of 12 months or less in expense without capitalization.
  • Including non-lease payments with lease payments when recording a lease asset and a liability.
  • Determining the discount by using an incremental borrowing rate or risk-free rate for private companies.

4. Educate Key Stakeholders on the Changes
The impact of this standard depends on the significance of the leasing activities; however, the financial statements of any entity with leasing activity will be impacted, and entities with significant operating leases will be significantly impacted. When the lease liabilities are added to your balance sheet, it could have an impact on financial leverage ratios that lenders will consider when making lending decisions.

Offering lease guidance to your organization’s board of directors and users of your organization’s financial statements (banks, bonding agencies, grant agencies, etc.) prior to issuing the first financial statements after implementation will alleviate surprises for these stakeholders.

Pay attention to industry specific implications
The updated lease standard impacts a wide variety of industries. Here are a few industry specific impacts to consider:

For healthcare entities, there is a unique consideration due to some of the types of lease agreements that have been developed. A primary example is lab equipment that the healthcare entity received for free after purchasing a certain level of reagent or other supplies within a certain timeframe. This type of arrangement is what is termed an embedded lease, and the agreement will need to be carefully reviewed to determine the lease component—likely, a right-of use-asset and lease liability will be recorded. There are other examples of this type of arrangement with radiology, IV pumps, etc.

Community Banks
The first step is to educate the bank’s management team with the general requirements of the standard. After spending some time going through the updated standard, the bank should prepare an inventory of all significant contracts it has with third parties. The reason for the inventory is to identify potential leases that could be embedded in standard third-party agreements. The definition of a lease will change with this latest standard, which notes property, plant or equipment can be the subject of a lease. Expect this inventory to take some time, as most agreements are not all housed in one central place at a bank.

Once you have a complete inventory of all leases, the bank will need to consider updating the process and controls surrounding entering into, modifying and terminating a lease. The process and controls should be established to ensure accurate and consistent records are kept reflecting the proper accounting associated with the updated lease standard. There will also be additional financial statement disclosures under the latest lease standard, and controls need to be implemented to support management’s significant judgments and estimates.

The final step will be evaluating the impact of the updated lease standard on the community bank. The Federal Financial Institutions Examination Council posted their Supplemental Instructions for the Second 2018 Call, number 284. In these instructions, the agencies noted that a right-of-use asset must be risk weighted 100% under Section 32(I)(5) of the agencies’ regulatory capital rules, and the asset will be included in the institution’s total assets for leverage capital purposes. Based on the accounting for the updated lease standard, it is possible to have a cumulative effect adjustment to retained earnings on the date of adoption. In addition to these regulatory capital and equity impacts, the bank could have covenants on borrowings that might be affected by these changes.

The Importance of Preparation for Accurate Implementation
There are a lot of considerations and activities that need to occur when implementing the updated lease standard. Contracts need to be complied and assessed for leases, decisions about technology need to be made, and implementation strategies need to be considered.

Want to know how to plan for the leasing standard? We've developed a guide to help.

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