Questions Arise Around Private Company Application of Lease Accounting Standard
Private Companies and Nonprofits Must Comply This Year
As private companies and nonprofit organizations prepare to transition to the new lease accounting standard, the experience of companies that have already adopted the standard is proving valuable in highlighting questions about how to report certain lease obligations.
The Financial Accounting Standards Board (FASB) issued ASC 842 Leases in 2016, requiring businesses and nonprofits to adopt new financial reporting practices regarding lease obligations. Public companies were required to comply with the new standard in 2018, but the implementation deadline for private companies and nonprofits has been extended several times, most recently due to the COVID-19 pandemic.
But the delays are behind us, and all private companies and nonprofits must adhere to the new reporting standard in their 2022 financial statements.
Some companies adopted the new reporting standard early and have encountered thorny questions when applying ASC 842 to private companies. Financial reporting standards issued by FASB often are written with large publicly held companies in mind, creating a disconnect when it comes to smaller privately held businesses.
There have been many questions around related party leasing arrangements. One primary question that has arisen is how to account for a month-to-month leases with related parties where the related parties know the lease will likely continue for a long time. It is common practice for operating entities to lease property from a related entity or an entity under common control to protect assets in the case of bankruptcy.
Since the new standard applies explicitly to “long-term” leases – those with 12-month terms or longer – there is a question as to whether the new reporting standard would apply. The answer is, it depends. The prevailing thought is that under ASC 842 the lessee should consider all legally enforceable explicit and implicit terms of the lease. Explicit terms of the lease include any terms which are in writing. Implicit terms of the lease may include consideration of if the lessee has constructed long-term leasehold improvements and would these improvements prohibit them from canceling a month-to month lease. If so, there may be implicit terms of the lease which are not in writing.
Subtleties and unique situations affecting many leases will determine whether they are subject to the new lease accounting standard, so it’s important to work with an advisor who understands ASC 842.
Why Does it Matter?
The new lease accounting standard is a financial reporting change to the makeup and presentation of the financial statements. So why does it matter?
The new reporting standard requires operating lease obligations to be shifted on to the balance sheet, resulting in the appearance of a new lease liability. Previously, operating leases were reported in the disclosures section of a financial. Under the new standard, they will be recorded on the balance sheet as a liability, with a corresponding “right of use” asset.
For example, a five-year lease for a photocopy machine might appear as a $6,495 liability ($1,500 a year for five years, discounted by an implicit rate of 5 percent), with a corresponding $6,495 “right of use” asset.
While the company leasing the photocopier – or big-ticket items like office space and vehicles – has not added any financial obligations that it didn’t have last year, adding the leases to the balance sheet creates the appearance of having taken on more debt.
It could impact lines of credit since the lease liabilities will affect a company’s debt-to-equity and working capital ratios. Some banks are out in front of the change and are proactively rewriting loan covenants to accommodate it, while other banks will likely issue covenant waivers for this year.
Effective Borrowing Rates
Another issue that has arisen is the issue of calculating discount rates that apply to lease obligations. The Private Company Council, a body that advises FASB on matters relating to private companies, has determined that private companies may use the “risk-free rate” in calculating the rates that apply to their leases. The risk-free rate is the theoretical rate of return of an investment with zero risk and is typically tied to U.S. treasury securities and is lower than most businesses have as an effective borrowing rate.
If an organization does not know a rate implicit in a leasing arrangement nor do they know what their borrowing rate is, this makes the calculation easier but has the negative effect of a higher right-of-use asset and liability than if the organization’s actual effective borrowing rate is used or the implicit rate in the lease is used.
Additional questions undoubtedly will arise as private companies transition to the new lease accounting standard. Contact your Adams Brown advisor with any questions about your organization’s transition to ASC 842.