Bringing Leases into your Books (Intro to ASC 842)

For anybody in the accounting world, one thing is clear: accounting standards never stay the same. The latest update to US GAAP accounting standards is here for nonpublic companies and it’s a doozy: bringing leases onto the balance sheet for lessees. The changes from this new accounting standard could come as a shock for those companies with balance sheet related metrics and/or financial covenants. Let’s take a look into the key changes with the revised accounting standard for leases under ASC 842.

I’m not sure what they were feeding FASB members/employees during the 2010s, but they were operating on another level with their accounting initiatives. In addition to the recently revamped guidance for revenue recognition under ASC 606, the FASB shortly after announced an overhaul of another major accounting topic: leases.    

Under the old leasing guidance (ASC 840), companies who were the lessee in a leasing arrangement evaluated new and existing leases as either operating or capital leases, based on certain conditions being met in the classification model. If a lease met any 1 of the capital lease criteria, then it was required to be accounted for as a capital lease, with the underlying nature that the company would control the underlying asset for the majority of its utility. In practice, this meant that a company needed to recognize an asset and corresponding liability on its balance sheet, consisting of the present value of all contractual future lease payments, and amortize the asset/liability over the lifetime of the lease. If none of the capital lease criteria were met, then the lease was considered an operating lease and subject to simpler accounting treatment; no asset or liability was required, and lease payments were simply recognized as expenses on a straight-line basis over the life of the lease.    

Key changes with the introduction of ASC 842 

While the new guidance under ASC 842, Leases, does not significantly affect the accounting conclusion for lessors or lessees with capital leases (now renamed as “finance leases”), one of the critical changes under ASC 842 relates to a company’s accounting for its operating leases as the lessee. The simplified accounting treatment of straight-line rent expense is no longer the only task; a company must now recognize an asset and liability for the future lease payments, similar to a finance lease. The impact of this change is significant for just about any company with an office or other real estate lease, as its balance sheet will increase with new assets and liabilities. This could skew the reporting of balance sheet KPIs, and result in the unexpected violations of debt financial covenants related to keeping liability amounts/ratios low.    

Another key change to consider is that the new leasing guidance of ASC 842 brings a new definition of what qualifies as a lease. While somewhat similar to the old definition under ASC 840, there are subtle changes that could cause certain arrangements formerly outside the scope of leasing guidance to now fall within it, or vice versa. As a result, many investors and audit/review teams require companies to evaluate all new and existing arrangements involving a physical asset, to determine if any previously unidentified leases exist which require lease accounting. 

Similar to ASC 606, the new leasing guidance of ASC 842 has been circulating in the accounting world for some time. In fact, the FASB started releasing guidance as early as 2016. Publicly traded companies have already been required to adopt ASC 842 for fiscal years beginning after December 15, 2018 (calendar year 2019). However, this may come as a surprise one-two punch for many nonpublic companies who recently finished adopting ASC 606, as nonpublic companies are required to adopt ASC 842 for fiscal years beginning after December 15, 2021 (calendar year 2022). Therefore, 2022 will be the year of ASC 842 implementation for many private companies, and navigating the complex guidance while performing a deep dive for any unidentified leases can become a time-intensive process that should be started sooner rather than later. 

In our next article, we’ll dive into a few key tips on how to start the ASC 842 implementation process for your company, and why it’s important to begin sooner rather than later.

If part of a nonpublic company, how prepared are you for the new lease standard?