4 Tips to Implement Lease Accounting Rules, ASC 842:
What private organizations can learn from public companies.
After two one-year extensions, Accounting Standards Codification (ASC) Topic 842 – the first new major lease accounting changes in more than 40 years – will take effect for private companies and private nonprofit organizations for fiscal years beginning after December 15, 2021.
Currently, these organizations treat equipment, real estate and other property subject to operating leases as off-balance sheet items. ASC 842 requires them to record these lease obligations on their balance sheets. Short-term leases, those with a term of 12 months or less, may still be excluded from the balance sheet if the lessee elects to do so in a disclosed accounting policy.
For financial reporting purposes, a lease obligation is classified as either an operating lease or a finance (formerly known as a capital) lease. While ASC 842 doesn’t require significant changes to the accounting for finance leases, operating leases are another matter. Under the new rules, the present value of future lease payments must be recorded on the lessee’s balance sheet as both a right-to-use asset and a lease liability. Prior to ASC 842, property subject to operating leases was not recorded on the balance sheet, only as rental expense in the income statement and in footnote disclosures.
Both the impact of this rule change, and the effort needed to implement it, can be significant, as the public companies and public not-for-profits that have implemented ASC 842 for fiscal years beginning after December 15, 2018 can now attest. Private companies and nonprofit organizations now have the benefit of learning from their experience as they develop their own ASC 842 implementation strategies. Here are four suggestions to consider:
Start compiling your leases now.
The 2021 implementation date may still seem like a long time off, but organizing your operation’s leases may take more time and effort than you might think. While the leases for a trucking fleet or real estate may be readily available, others may be embedded in service agreements or other contracts. An IT service agreement, for example, could contain a lease for servers and other computer equipment. A contract manufacturing agreement may include a lease for dedicated packaging equipment. An advertising contact might involve a billboard lease.
To identify all the potential leases that might be subject to ASC 842 requirements, you may need to meet with departments throughout your organization to determine which, if any, of their assets are leased as part of a larger contract. In some cases, contract modifications may be needed, which the affected departments may need to help to plan and negotiate. By compiling and maintaining copies of these lease documents in a single depository, your accounting team can apply similar processes to their management and help assure ASC 842 compliance.
Familiarize yourself with ASC 842’s disclosure requirements.
ASC 842 significantly increases lease disclosure requirements to include critical dates in the lease term, the total amount paid under a lease and relevant right-of-use information. It also requires you to collect and monitor some lease data that may not be contained in current lease agreements.
For example, ASC 842 asks organizations to identify discount rates or fair market values for lease calculations, both of which may be based on management assumptions and estimates. If this information is outdated or does not exist, staff will need to update or identify it. Given the number of amendments in some leases, it can sometimes be challenging to find proper data sources to support for this information. It can also take more time to model different valuation scenarios, prepare financial disclosures and address other ASC 842 compliance and management reporting requirements. Developing standardized or automated processes for lease tracking and ASC 842 compliance can help minimize this time commitment.
If minimizing balance sheet liabilities is important, work with a financial institution or lessor that can offer alternatives.
Even with ASC 842, there may be strategies you can follow to help minimize on-the-book lease obligations. Consider, for example, a company that wishes to lease a $100,000 truck for four years. It arranges with its bank to pay $1,000/month for 48 months before returning the truck or purchasing it at its then fair-market-value value.
Currently, a private company would not include the $100,000 price of the leased truck on its balance sheet, including only its monthly lease payments on the income statement. A footnote would disclose the remaining payments over the 48-month term. With ASC 842, the present value of the remaining lease payments would represent an obligation and is added to the balance sheet.
The accounting treatment for any lessee guarantee on the residual value of the truck also changes. Before ASC 842, the entire amount of any residual value guarantees was included in the calculation of the lease payment obligation. With ASC 842, only the portion of the residual value guarantee expected to be owed at the end of the lease term is included when determining the lease liability.
If you wish to minimize your balance sheet liabilities, financial institutions or lessors knowledgeable in ASC 842 provisions may be able to offer lease terms, residual guarantees, contingent rentals and other alternatives to economically accomplish your objectives.
Review the ASC 842 implementation impact on your balance sheets with your accounting firm to ensure accuracy and protect against unexpected financial covenant violation.
Because ASC 842 implementation can be complex, it’s wise to ask your accounting firm to review your balance sheets to see that your equipment, real estate and other operating leases have been recorded properly and in accordance with the new rule. Those who have experience in implementing ASC 842 for public companies and public not-for-profits may be able to offer valuable insights and help prevent noncompliance.
The bottom line: As public companies have discovered, implementing ASC 842 impacts more than an organization’s accounting department. The new leasing standard requires significant new financial statement disclosures. To be prepared for its 2021 start date, private companies and nonprofits should begin putting the appropriate processes and controls in place.
At Commerce Bank, we stand ready to help your business face a number of challenges. Contact us to learn more about financing and leasing solutions from Commerce Bank.