Leasing Standards Change: Transition from ASC 840 to ASC 842

Let’s begin by discussing how we got here. The change from ASC 840 to ASC 842 can be traced back to the start of the new millennium, a time when fraud was at the forefront of regulatory concern due to organizations such as Enron and WorldCom. In light of scandals with these companies, which prominently included leases, the Financial Accounting Standards Board (FASB) along with the International Accounting Standards Board (IASB) formally agreed in 2006 to overhaul lease standards. Over the next decade, both organizations endeavored to craft revised regulations which culminated with FASB’s release of ASC 842 on February 26, 2016 (IASB’s version was released on January 13, 2016). In addition to updating regulations, FASB outlined an implementation plan for the rollout. After a small delay in implementation for private companies due to COVID-19, the new standard is now effective for all organizations with financial statement years beginning after December 15, 2021.

Leasing Standards Change: Differences in New Leasing Standard

Now let’s examine what some of these changes are. The biggest change for most organizations is that lessees are now required to recognize operating leases on the balance sheet instead of simply disclosing in the footnotes. This is achieved by recording “Right of Use” asset and liability accounts that largely counterbalance each other over the life of the lease.

Under the new regulation, there are three types of leases: short-term, finance, and operating. A lease is considered operating if it does not qualify as short-term or finance.

Short-term leases, those with an original lease term of less than 12 months, and true month-to-month leases are excluded from the balance sheet requirement and will continue to be reported as periodic lease expense.

A lease is considered a finance lease (formerly known as a capital lease) if one of the following criteria is met:

• Transfer of ownership at end of lease
• Purchase option that is reasonably certain of exercise
• Lease term is a major part of economic life (think 75%)
• Present value of lease payments plus guaranteed residual value represents substantially all the value (think 90%)
• The underlying asset is so specialized that there is no alternative use for the lessor

The organization must closely review lease terms to understand the impact they may have on the calculation of assets, liabilities and expense.  Some specific terms to pay attention to include:

• Fixed lease payments
• Variable lease payments that depend upon indexes or other rates
• Penalties for lease termination
• Exercise price of any asset purchase option
• Fees paid by the lessee to the lessor
• Any residual value guarantee
• The relevant discount rate

How to Prepare for the New Standard?

There are a few steps that all organizations can take to ensure they are ready for the transition.

1. Evaluate lease population. The most obvious first step is to compile lease documentation for existing leases.  The less obvious step is to identify and accumulate documentation for obligations that may not at first look like a lease.  Leases can be found in many kinds of service contracts, including:
   1. Service agreements (software, for example)
   2. Office equipment (postage meters, printers, copiers, etc.)
   3. Storage (warehouses, for example)
   4. IT service arrangements (dedicated server in a cloud environment, for example)
   5. Vehicles

2. Document informal leases, particularly those with related parties. Undocumented leases can be problematic, leaving key terms open to interpretation which can then lead to unanticipated or unwanted outcomes.

3. Evaluate lease data. Data requirements are fairly extensive, and include the following:
   1. Lease term/dates, including lease commencement, termination and dates for options such as extensions and early terminations
   2. Payment details, including timing of payment (advance or arrears), fixed payments, variable payments (those tied to an index, for example), residual value guarantees, allowances or incentives received from the lessor
   3. Discount rates, which in the order of priority, would be the explicit (stated) rate in the lease, the implicit rate if determinable, the organization’s incremental borrowing rate, or an election to use a risk-free rate

For those with a large number of leases, these steps cannot begin soon enough. The extra compliance work may be limited for those with fewer lease obligations, but for those with multiple leases, the work could be extensive.

Implementation and Effects

As mentioned above, ASC 842 implementation is required for financial statement years beginning on or after December 15, 2021. For most private companies and not for profit organizations, this standard will be adopted with current year financial statements.

The good news is that GBM is here to help.  The firm has partnered with software provider NetLease to assist with management and implementation of the new lease standard. This software is critical in helping to automate the process and in assisting with technical decisions and calculations. At the client’s option, GBM can handle all interactions with the software. Alternatively, GBM can facilitate an introduction to NetLease whereby the client controls all inputs.  Those with fewer leases may qualify for free access to the software, while those with more can obtain preferential pricing through GBM’s relationship. Irrespective of the option, we anticipate a seamless integration with NetLease.

Contact a GBM member for more information.

Lee Fox, CPA