Compile ‘Lease Inventory’ to Comply with New Reporting Standard
Look for Embedded Leases That May Be Impacted
There’s no more putting it off. For private companies, ASC 842 – the new lease accounting standard – is in effect for 2022. That means at the end of this year companies will need to report leases on their balance sheets as liabilities and corresponding assets, rather than as commitments in the notes of their financial statements.
If your company has not yet started the process of complying with the new standard, the most important message right now is – don’t wait until the end of the year to start this project.
Complying with the new lease accounting standard will require compiling an inventory of your organization’s lease obligations before properly calculating the assets and liabilities they represent. This may sound simpler than it is.
Inventory of Leases
Depending on the size and complexity of your company, you may have a good idea of how many lease commitments you have. The large ones are obvious, such as fleet vehicles, warehouse space and office space. You may also lease office equipment such as large photocopiers, as well as operational equipment.
But there may be “embedded leases” contained in large contracts that also must be reported under the new lease accounting rule. Embedded leases are common in certain industries, including healthcare. They often involve a company providing equipment to your organization in exchange for a commitment to purchase the supplies to run the equipment over a multi-year period.
Other types of agreements also may be covered by the new lease accounting standard even though they are not called leases. Phone systems are one example, where a provider installs phones in your company in exchange for a multi-year service agreement.
Smaller short-term leases – those that involve commitments of less than 12 months – do not have to be reported on the balance sheet under the new rule.
When the inventory of leases is compiled, you can determine whether to purchase lease accounting software to help calculate the liabilities. You must make a net present value calculation of your future minimum lease payments, then discount that back to today’s dollars to reach the lease liability. The “right of use” that the lease provides is recorded as a corresponding asset.
For a small number of leases, you may be able to calculate the liabilities without purchasing software. But you may want to consider the software if you have a large number of leases or complex leases.
More than 15 years in the making, the new lease accounting standard – ASC 842 – has been subject to multiple implementation delays, the most recent due to the COVID-19 pandemic. It took effect in 2019 for public companies and is effective this year (technically, for fiscal years starting after December 15, 2021) for private companies and nonprofit organizations. It applies to entities that enter into leases and subleases of property, plant and equipment, but does not apply to:
- Leases of intangible assets
- Leases to explore for or use resources such as minerals, oil and natural gas
- Leases of biological assets such as timber
- Leases of inventory
- Leases of assets under construction
The primary objective of the new standard is for lessees to report a liability or obligation with transparency. Previously, lease obligations were disclosed in the financial statement as a commitment. Under the new standard they are reported as liabilities. As such, they have now moved to the balance sheet with the present value payment stream reported as a liability, with an offsetting entry quantifying the “right of use” that a lease entitles you to. The imputed interest rate can be calculated in different ways, and the Financial Accounting Standards Board (FASB) recently issued an expedient way to use the fed funds discount rate to determine the present value of the payment stream.
If you have not yet started the process of complying with ASC 842, commit to the following steps very soon:
- Compile your lease agreements, sublease agreements and any contracts that may include embedded leases.
- Build a spreadsheet of these leases, including data on the lease terms and a clear description of the right of use asset.
- Contact your accountant or advisor for guidance on whether lease accounting software would benefit your organization.
- Contact your financial institution to discuss the impact the new financial reporting standard will have on your lending relationship. The new standard will not affect your company’s revenue, but it may impact certain financial ratios that are considered by lenders in formulating debt covenants. Most lenders are aware of the new reporting standard and understand its potential impact. But if you are in the process of refinancing debt, talk to your lender about the potential change in your 2022 balance sheet from 2021 to avoid problems with debt covenants down the line.
If you would like to discuss a process for building your lease inventory and complying with ASC 842, contact your Adams Brown advisor.