Accounting standards codifiction 842 is the new lease accounting standard that replaces the previous leasing standard 840. The new standard aims to overcome the major loophole in ASC 840 - "Off-Balance Sheet Operating Leases."
Up until the new standard was introduced, accounting for leases required lessees to classify leases as either a capital lease or an operting lease. Capital leases were recoreded on the balance sheet. In contrast, opertating leases were disclosed as a footnote in the financial statements as "Off-Balance Sheet" operating expenses. Therefore they were excluded from critical financial ratios that allow stakeholders to judge a company's performance.
This difference in accounting treatments made it difficult for investors to judge the company's indebtedness accurately; hence, the requirement of ASC 842 came up for the proper presentation of the lease in the balance sheet.
Below is a summary of some significant differences for leases on the lessees’ books:
All of them. Related party and non-related party leases, office/facility leases, equipment leases, vehicle leases…you name it. If you have capital leases or rent on your books, then this includes you.
You are required to have your leases fully converted to the new standards on January 1, 2022.
Financial reporting changes could potentially impact debt covenants, key performance indicators (KPIs), cost of capital decisions, and other strategic planning efforts.
Financial statements will be impacted by the lease-related assets, receivables, and liabilities. Your lenders and bonding agents will be on the lookout for these changes.
Internal training, policies and procedures, and new internal controls regarding the application of the new lease standard will need to be implemented.
Significant judgments, estimates, and periodic revision of estimates will be required, including testing for the potential impairment of right-of-use assets. (ASC 842)
Documenting the judgments required to implement the standard (including practical expedients and accounting policy elections) is critical for audit preparedness. (ASC 842)
A lot of time and effort will be needed in order to properly execute the lease conversion and to maintain the books with the new lease standards.
Roofing Co. leases an office space with a 30-year economic life and alternative expected use to the lessor after the lease term. The lease conveys no ownership at the end of the lease term, no purchase option, and requires no guarantee of residual value. Below are more details about the lease terms:
Lease term: 5 years
Start date: 1/1/2020
Monthly lease payments: $5,000
Implicit interest rate: 3%
The lease is determined to be an operating lease, but the lease term is greater than 12 months, so the new standard requires balance sheet presentation.
We first calculate the initial lease liability
At 1/1/2020 the balance sheet will have the following:
An operating lease right-of-use asset $274,782
An operating lease liability of $274,782
For the first year, we amortize the operating lease liability and right-of-use asset down to a balance of $222,298.
Balance Sheet as of 12/31/2020
Income statement for the year ended 12/31/2020
This change in lease accounting is the most significant and complex in the last 20 years, and it’s time to be proactive about it. While this article includes an elementary but common type of lease, many more rules embedded in this standard need to be addressed when implementing these changes.