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Upcoming Changes to Accounting for Lease Arrangements

Update published on June 5, 2020: FASB issued Accounting Standards Update (ASU) 2020-05, Revenue from Contracts with Customers (ASC 606) and Leases (ASC 842) Effective Dates for Certain Entities, as part of its efforts to support and assist stakeholders as they cope with the many challenges and hardships related to the COVID-19 pandemic.

Update published on December 10, 2019: Effective dates have been deferred for non-public companies until annual financial reporting periods beginning after December 15, 2020 (2021 for calendar year-end companies).

Accounting Standards Codification (ASC) Topic 842 (ASC 842) is the new lease accounting standard that is effective for calendar year-end non-public companies beginning January 1, 2020. Under this new standard, all companies reporting under U.S. GAAP will be required to record all lease arrangements longer than 12 months in duration on their balance sheet – there will no longer be off-balance sheet treatment available for certain lease arrangements based on lease classification.

What does this mean for my company?

Companies, large and small, use lease arrangements to obtain the use of assets that they do not own or wish to purchase. Under current U.S. GAAP, all lease arrangements must be classified as either “operating” or “capital” leases. Companies are only required to record leases that are classified as capital on their balance sheet. Any lease arrangements that qualify to be classified as operating are considered off-balance sheet.

Arrangements identified as leases (as defined in ASC 842) will continue to be required to be classified into two categories under the new standard – “operating” and “finance” leases. However, ASC 842 will require both operating and finance leases to be recorded on the balance sheet, regardless of classification. Companies will record a right-of-use asset on the balance sheet and a corresponding liability for the lease obligation. This will affect financial metrics commonly used by sureties and lenders in determining the creditworthiness of a company, including current ratio, leverage ratio, and return on assets.

How will I implement the new standard?

In order to reduce the burden of implementation, ASC 842 provides a relief option in adopting this new standard. If this option is applied, companies will not reassess arrangements existing at the adoption date (January 1, 2020 for calendar year-end non-public companies) to determine whether the arrangement is a lease or contains a lease. In addition, existing lease arrangements would not be reassessed for proper classification under the new guidance. Any arrangements already in effect and classified as capital leases would generally be recorded as finance leases at their present asset and liability balances. Lease arrangements formerly classified as operating leases would continue to be classified as operating. A right of use asset and lease liability would be recorded at the present value of the remaining lease payments.

New agreements, as well as certain modifications to existing agreements, that are effective on or after the date of adoption will require assessment under the terms of ASC 842. This assessment will be used to determine if an arrangement meets the criteria of a lease, or contains a lease, under the new standard. Determining whether an arrangement contains a lease is critical since virtually all leases will require recognition of an asset and liability. Some key differences between current U.S. GAAP and ASC 842 in assessing these arrangements are as follows:

  • An arrangement contains a lease under ASC 842 only when such arrangement conveys the right to “control” the use of an “identified asset.” Under current U.S. GAAP, an arrangement can contain a lease even without control of the use of the asset if the customer takes substantially all of the output over the term of the arrangement.
  • The right to use land is considered a separate lease component under ASC 842 (unless the accounting effect of accounting for it separately would be immaterial). Ground leases are considered to be operating under current U.S. GAAP, but under ASC 842, these must be considered for classification as operating or finance. Long-term ground leases are generally expected to be finance leases under ASC 842.
  • Initial direct costs are defined as incremental costs of a lease that would not have been incurred if the lease had not been obtained. Certain incremental costs previously eligible for capitalization will be expensed under ASC 842.

The implementation of ASC 842 will impact the balance sheet of nearly every company, large or small, as virtually all leases will require recognition of a right-of-use asset and a lease liability. If you’d like to discuss specific considerations for your company, please contact us.

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