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After two delays, the new accounting lease standard (ASC 842) will finally take effect for private companies in fiscal years beginning after December 15, 2021. This means many private companies will soon be required to include long-term lease obligations on the balance sheet for the first time. Unfortunately, many may not yet be ready for the change. Lessees will now recognize all leases, including operating leases, with a lease term greater than 12 months on their balance sheet. Given some of the complexities in the new standards, it is likely that several departments within an organization may need to be involved in lease identification and review. The transition will be easier for some industries, but for others in the construction, manufacturing, and real estate industries, they may have a more difficult time. Even though it seems like there is plenty of time to plan for the new lease standards, the deadline is quickly approaching. To help clients, prospects, and others, JLK Rosenberger has provided a summary of the key details below.
What’s Changing in the New Lease Standards?
This represents one of the most extensive overhauls to financial reporting in years. When public companies were adopting the standard, it was estimated to have the “largest-ever impact of a new accounting standard in terms of gross dollars on the balance sheets of lessees.” A recent estimate put the increase in public companies’ total assets and liabilities at about $1.5 trillion each.
Implementing the requirements will involve more than just financial reporting. As the deadline inches closer, private companies can look to public companies for expectations of how the transition may go. Expect impacts across several departments, including technology, tax, finance, and more.
Under the new standard, the definition of a lease is changing. A company, or lessee, must have direct control over the asset or should be able to direct its use, as well as realize most of the benefits from using the asset over its lease term.
There are still operating and finance leases; however, the biggest change is that operating leases must be recorded differently going forward. Operating leases must be accounted as an asset and liability on the balance sheet. The most obvious examples of operating leases are in long-term rentals of machinery, equipment, vehicles, and real estate, although other assets fall under the new rules, as well.
To determine what constitutes a lease under the new rules, companies can follow this five-part test:
- Is ownership transferred when the lease term ends?
- Does a bargain purchase option exist for the asset?
- Is the lease term mostly for the remaining economic life of the asset, or does the lease term begin near the end of the asset’s useful life?
- Are the lease payments’ present value and residual value guarantees equal to or more than the asset’s fair value?
- Is the asset specialized enough that it doesn’t have any other alternative use to the lessor once the lease term is up?
The first four lease criteria are similar to current standards, while the fifth one relating to specialized assets is new. How operating leases are measured is also changing. Any lease term of more than 12 months must be recorded on the balance sheet. And for every lease term longer than 12 months, the lessee should demonstrate its direct control. Lease obligations must also be measured every period, and indirect costs in acquiring the leases – like broker fees – must be accounted for. All of this will result in substantially more work for large or complex leases.
Common Adoption Issues
There are some common pitfalls that many private companies encounter when they begin to implement the new lease standards. Identifying embedded leases can be challenging across all industries, but it is an important first step to ensure all leases are accounted for. This goes hand in hand with locating and reviewing every lease contract and verifying the accuracy of the data within the contracts.
Other common issues that many companies can expect include standardizing procedures, updating internal controls, and understanding new disclosure requirements. Compliance will depend upon the processes by which leases are negotiated, renewed, and modified. Implementing the new standards will likely bring departments closer to being on the same page than they were before.
Under the new standards, lease components within a contract must be separated and non-lease components segregated. Identifying, determining, and carrying out this new reporting may be difficult. The sheer volume of new disclosure requirements can be difficult to navigate. Lease accounting software can help streamline compliance in some areas, but it is not a substitute for understanding how the changes impact various parts of the business. When it comes to education, awareness, and training, the finance team should work closely with their external auditor.
We’re Here to Help
The changes to the lease accounting rules will require companies to carefully review and account for leases differently than in the past. As the compliance deadline is quickly approaching, it is important not to delay. If you have questions about the information outlined above or need assistance with lease accounting changes, JLK Rosenberger can help. For additional information call us at 949-860-9902 or click here to contact us. We look forward to speaking with you soon.