In early 2016, the Financial Accounting Standards Board (FASB), the body that sets accounting principles for U.S. entities, released a new accounting standard on how businesses should account for their leases. Many leases that were previously sequestered to the income statement must now be recorded as assets on the balance sheet along with an accompanying liability that represents the remaining lease payments.
Accounting Standards Update (ASU) 2016-02, Leases (Topic 842) became effective for public entities for fiscal years beginning after December 15, 2018. Non-public entities were initially told to implement the standard for fiscal years beginning after December 15, 2019, but when COVID-19 emerged, the American Institute of CPAs (AICPA) lobbied to delay the effective date.
The AICPA’s lobbying efforts worked. To help alleviate stress for private companies during the challenges of the pandemic, the FASB voted to delay the effective dates of the lease accounting standards for private companies (including private nonprofits) by two years. Private entities must now apply the new standard to fiscal year reports for periods that begin after December 15, 2021 and to interim reports for periods that begin after December 15, 2022.
The deadline for calendar year entities is imminent. As you begin reporting under these new standards, there are a few things you need to remember.
If you lease tangible assets, this is going to affect you.
The new accounting standard is far reaching. It applies to almost all types of leases, including variable leases, fixed leases, leases with purchase upon termination (PUT) options, and sale/leaseback agreements. It also applies to leases of all types of tangible property, including leases of real estate, vehicles, machinery and equipment, and computer systems. But keep in mind that this new accounting standard generally only affects lessees. Lessees are parties who lease and use assets that somebody else owns.
What qualifies as a lease under Topic 842?
Not all agreements are easily identifiable as leases. In general, a lease is the right to use an asset over a certain period in exchange for some form of consideration, although there are a few exceptions to this rule. The following types of agreements need not be accounted for under Topic 842:
- Leases of inventory
- Leases of construction in progress
- Leases of intangible assets
- Licenses of internal-use software
- Rights to explore for natural resources
- Leases to use natural resources
- Leases of biological assets like living plants or animals
- Service concession arrangements
- Leveraged leases
- Term less than 12 months with no intent to renew
It’s also important that you only apply Topic 842 to the lease itself. Some contracts include both lease and non-lease components. The non-lease components may be identified and accounted for separately, outside of Topic 842. However, there is a practical expedient which allows lease and non-lease components to be combined and all considered as lease costs.
Non-lease components of a contract are any costs not directly related to acquiring the use of the leased asset. This means that maintenance agreements, administrative costs, installation costs, training expenses, taxes, and insurance may need to be accounted for separately from the rest of the contract. There are a few different ways to allocate the contract price to non-lease components, but most methods require you to allocate based on the stand-alone price of each non-lease component.
It is important also to identify any embedded leases. An embedded lease is a lease contained within a larger agreement such as a service contract. Common scenarios in the construction industry that have embedded leases are IT service contracts, manufacturing contracts, and transportation contracts.
What’s the impact to your financial statements?
Under prior guidance, Generally Accepted Accounting Principles (GAAP) allowed companies to segregate their leases into two broad categories – capital leases and operating leases.
A capital lease was recorded when an entity leased an asset for a long-term period, typically for over 75% of the asset’s entire useful life; if there was a bargain purchase option; if the present value of future lease payments exceeded 90% of the fair value of the leased asset; or if the lease transferred ownership to the lessee at the end of the term. A capital lease was recorded on the balance sheet as an asset and as an offsetting liability for the value of the remaining lease payments.
An operating lease was recorded when an entity leased equipment for a short-term period, like for equipment that is upgraded or traded out each year. An operating lease was recorded on the income statement as “lease expense” and left off the balance sheet altogether.
Under the new accounting standard, these rules changed.
While the treatment of capital leases (renamed “finance leases”) generally stayed the same, operating leases must now be recorded on the balance sheet. Both finance and operating leases must be recorded on the balance sheet as (1) a “right of use” non-current asset to represent the company’s right to use the asset for the lease term, and (2) an accompanying current and non-current liability for the present value of the remaining lease payments. The only leases that can remain off the balance sheet are short-term leases. Businesses that want to leave short-term leases off the balance sheet must make an election not to apply Topic 842, and they must do so for each asset class rather than making a blanket election for all short-term leases. In general, short-term leases must be less than 12 months in duration, and there cannot be an implied obligation or expectation to renew the lease at the end of the period.
Income statement and statement of cash flows
All lease activity will pass through the income statement at some point. Operating lease payments will be reflected as “lease expenses” and will typically be recognized over a straight-line period, while finance leases will be reflected as “amortization expenses” over the life of the right-of-use assets, and, separately, interest that accrues on the lease liability.
All cash payments will flow to your statement of cash flows just as they do under current GAAP guidelines, but the classification of cash activity may be different.
- Payments on short-term and operating leases are typically classified as operating activities.
- Variable lease payments on finance leases are also classified as operating activities.
- Repayment of the principal portion of finance leases are classified as financing activities.
- Cash paid to make the asset ready to use (like set-up and training costs) are considered investing activities.
This chart illustrates how to account for leases that are already in place but will need to be transitioned to conform to the new standard in the year of the transition.
This chart illustrates how the initial and subsequent measurement entries will be accounted for a new operating lease for both the balance sheet and income statement.
You should have conversations with your bankers and bonding agents.
Understanding the impact of this new accounting standards update on your financial statements is important when negotiating financial covenants with bankers and meeting financial ratios for bonding purposes.
The standard will create a current liability but not a current asset, which will in turn affect your working capital ratio. As working capital is a major component in your bonding capacity, this may be a cause of concern for your bonding agents.
Similarly, your bankers expect you to maintain certain financial ratios, and they outline those expectations in your debt covenants. Therefore, the new leasing standard may put you at risk of breaching those agreements. Return on assets (ROA), for example, shows the percentage of profit you earn (“net income”) in relation to your resources (“total assets”). When your assets increase because of this new leasing standard, your ROA ratio will decrease. If your bank requires you to operate with a certain ROA, you may default on your loan for being in violation of your financial covenants.
Before you release Topic 842-compliant financial statements, talk to both your banker and your bonding agent. Many banks and bonding agents understand that the leasing standard only artificially alters your financial ratios. Bonding agents may incorporate these balance sheet changes into their analysis when determining your bonding capacity, and some bankers will happily adjust your debt covenants accordingly, but not all will.
You need to think about your transition now.
The effective date for nonpublic entities is approaching. Calendar year entities must begin calculating leases under the new standard beginning January 1, 2022. Their annual report for the year ending December 31, 2022 must reflect the new guidance, along with all interim and annual reports thereafter.
Although you do not need to report the changes until early 2023 when your 2022 annual report is due, you need to be thinking about the changes now. If you haven’t already, we recommend that you first read and familiarize yourself with the standards – including the transition requirements – to determine how your organization will adopt the new standard. A dedicated task force can be especially helpful during the transition. This task force can:
- Track down and centralize lease agreements
- Review existing leases to gain a better understanding of the company’s leases
- Determine how leases will be classified between short-term, finance, and operating
- Establish a system for separating lease components from non-lease components in a contract and assigning consideration to each
- Research, test, and implement new lease software
- Establish internal controls for recording leases
- Review existing debt covenants and negotiate new ones
- Draft footnote disclosures
- Warn stakeholders of upcoming changes
- Request feedback from auditors for how to make the transition and future reporting easier
This task force should be comprised of personnel from several departments, including finance, accounting, project management and purchasing, so that all departments feel represented and understand how the standard will affect your company.
The FASB wants businesses to use a modified retrospective approach when transitioning to Topic 842. This approach does not require you to restate prior year activity, but you may do so if you wish. You can either:
1. Transition your reports as of the adoption date:
This would require you to post an adjustment as of the beginning of the transition year, but you would not need to restate any prior periods.
2. Transition your reports as of the earliest comparative period shown in your financial statements:
This will require you to restate three or more prior periods.
Whatever method you select, you must apply that method across the board to all leases. You cannot treat new leases and existing leases differently in the same reporting year.
You will need to collect a lot of information.
Topic 842 establishes new footnote disclosures to help users of the financial statements better understand the lease activity of a business. Both quantitative and qualitative disclosures about your leases must be reported in the footnotes to the financial statements, including the following information:
- How you identify a lease
- A description of each different type of lease
- Quantitative information about the different types of leases, including the value of the remaining payments, the portion of the lease that represents non-lease components (such as installation or maintenance), and how much of the standard rate has been discounted
- Acknowledgement of subleases to your subcontractors or any leaseback agreements
- Terms and conditions of lease agreements, including the interest rate, discount rate, due date, prepayments allowed, etc.
- Assumptions made on valuing variable lease payments
- Options available for each lease, including options to extend or terminate early
- Accounting policy election for the short-term lease exemption
Creating the internal controls needed to collect this information alone can be difficult and can take months to do so properly. These disclosures aren’t something you can easily create a month or two before you publish your financial report.
You may need new software.
As you begin to implement these new rules, you may find that you need new or different software to help you. Not only will you need to calculate the value of your lease payments, but you will also need to collect non-financial information about your leases to fulfill disclosure requirements.
When considering new lease accounting software, don’t focus on costs alone. Choose a software that will support your internal controls; work with your volume of leases; keep an audit trail of activity; have adequate reporting functions; notify you of errors or outliers; keep a depreciation schedule for both federal and state tax purposes; and is well-regarded by others in your industry.
Contractors may be affected more than the average business.
Quite often, contractors lease high-value equipment to use on their projects rather than owning a fleet, so this accounting standard change is likely to affect contractors more acutely than entities in other industries.
It is common for construction companies to treat lease expenses related to leases of machinery and equipment as indirect costs, then allocating these costs to contracts. With the implementation of the new standard, the accounts in your income statement will not change. Finance leases will still be included as amortization and interest expense and; operating leases will still be included as lease cost. The accounts used in developing your cost allocation pools should be reviewed to ensure all lease costs are being captured.
Understanding the impact of this new guidance on your financial statements is important. Contact a LaPorte professional if you need help implementing this new standard, and don’t delay; the deadline is quickly approaching.