Accounting Standards Codification (ASC) 842 is effective for private companies for years beginning after 12/15/21, so for companies with calendar year ends, your 2022 financial statements will need to be compliant with ASC 842.
Accounting Standards Codification (ASC) 842 requires capitalization onto the Balance Sheet of all leases with terms more than 12 months. The Financial Accounting Standards Board (or FASB) created this new standard to foster more transparency between investors and companies by moving information that was primarily in the footnotes in the past onto the Balance Sheet.
Under ASC 842, all leases are either considered financing (previously referred to as “capital”) or operating. The criteria for determination of a financing lease are the same as before:
Under ASC 842, companies must account for operating leases by recognizing a single lease cost allocated over the lease term, generally on a straight-line basis. All cash payments should be classified within the operating activities on the statement of cash flows. The lease asset is called a “right of use” asset and represents the total lease liability adjusted for certain items like prepaid rent or lease incentives.
The lease liability is measured as the present value of the lease payments over the term of the lease. Private companies cash use the risk-free rate as the discount rate as a practical expedient. This will simplify the calculations for private companies; however, it will cause higher lease liabilities.
When determining the term of an operating lease, companies should include reasonably certain lease renewals and purchase options. For example, if the lease is a month-to-month lease; however, the company is expected to continue to lease the asset for longer than 12 months. If the term is less than 12 months, companies can elect not to recognize the right of use of assets and corresponding liability but should recognize the lease expense on a straight-line basis.
Related Party considerations should also be addressed when determining the term of the lease under ASC 842. Determination should be based on implicit legally enforceable terms, and the classification should be the same as it would be for unrelated parties. Also, even if the lease is informal/verbal, it must be evaluated under ASC 842. Companies cannot get around ASC 842 by simply creating a month-to-month or annual lease with a related party.
If there are any implicit legally enforceable terms or conditions of a lease, management estimate of the lease term should be based on the implied intentions of the leased property.
A lessee leases a facility from a related party for five years with no option to renew. Significant costs are incurred by the lessee related to leasehold improvements that will retain significant value over a useful life of 20 years.
What do they need to consider?
“Each of these considerations should influence management’s determination of the term of the lease under ASC 842.”
When making financial statement footnote disclosures related to ASC 842, disclosures must be qualitative and quantitative. They should include:
ASC 842 also requires companies to evaluate embedded leases which can be buried in other types of agreements such as service contracts, equipment rental agreements, manufacturing contracts, or transportation contracts. Components to consider when evaluating embedded leases are:
Not sure where you are in the implementation process? Here’s a readiness checklist:
If you’re a construction contractor, there are also several additional considerations to think about pertaining to banking and bonding.
The end of the year is approaching, and now is the time to reach out to us to discuss your upcoming implementation of ASC 842. Call us at 858-430-0300 today.