In April 2020, Financial Accounting Standards Board (FASB) voted to defer the effective date of Accounting Standards Codification (ASC) 842, Leases for certain entities. Now effective for fiscal years beginning after December 15, 2021, all private companies will be required to adopt the new standard which will impact the way most lease agreements are reported and disclosed.
The principal change to lease reporting under ASC 842 is that lessees will be required to recognize assets and liabilities on the balance sheet for leases that were previously classified as operating leases. Previously, operating lease payments were recognized as an expense over the term of the lease and future obligations were disclosed in the notes to the financial statements. Lessees will now recognize a liability to make lease payments and a right-of-use asset that represents its right to use the underlying asset over the term of the lease. The amounts recorded on the balance sheet must be measured at the present value of the lease payments, and amortization and interest expense must be recognized separately on the statement of comprehensive income.
Private companies have decisions to make in determining the calculation of interest rates related to leases. ASC 842 instructs companies to use the implicit rate, or the interest rate being charged by the lessor, if it is available. Often times this rate is not accessible to the lessee so, in these situations, private companies are allowed to use either their incremental borrowing rate or the risk-free rate. The incremental borrowing rate is the interest rate a company would receive if it were to borrow an amount of money equal to the total of the lease payments over the lease term. The risk-free rate is the rate that investors expect to earn from an investment that carries zero risk over a period of time, such as government treasury bills. When choosing between these two options, companies should be aware that a lower interest rate will result in a higher liability on the company’s balance sheet.
It is important to note that when calculating the asset and liability, the lessee should include payments for optional extension periods as well, but only if there is reasonable certainty that the option will be exercised. For leases that have a term of 12 months or less, a lessee may elect to recognize lease expense on a straight-line basis over the lease term instead of creating an asset and liability.
For lessors, the accounting for operating leases remains fundamentally the same under Generally Accepted Accounting Principles (GAAP). Operating lease income should continue to be recognized on a straight-line basis over the terms of the lease.
Additional disclosures will also be required for the purpose of increasing transparency in financial reporting, including a breakdown of all operating and finance leases, as well as the current and noncurrent portions of their respective liabilities. Future minimum rental payments will continue to be disclosed as they were prior to ASC 842. New disclosures will include a summary of weighted-average remaining lease terms and the weighted-average discount rate used to calculate the lease liability.
Please contact your trusted TBC Advisor for more information about the impact that these new lease standards may have on you.