Accounting standard codification (ASC) 842 is the new lease accounting standard which replaces the previous leasing standard ASC 840. The new standard targets what is commonly referred to as “off-balance sheet operating leases”. Prior to the new standard, accounting for leases required lessees to classify leases as either a capital lease or an operating lease. Capital leases were recorded on the balance sheet, whereas operating leases were disclosed as a footnote in the financial statements instead of recorded on the balance sheet, and so labeled “off-balance sheet”. As a result, operating leases were excluded from important financial ratios that assisted interested parties to judge a company’s performance and indebtedness. Revisions to the standard were especially triggered by accounting scandals involving corporations such as Enron and WorldCom. The requirement of ASC 842 combats this by requiring presentation of the lease and its related liability on the balance sheet.
DELAYS / HISTORY
The new standard was added in February 2016 and was set to have an effective date beginning for nonpublic entities with year-ends December 15, 2020. In October 2019, to allow for additional time, the effective implementation date was pushed back one year. A second one-year delay was issued in June 2020 to allow organizations relief during the COVID-19 global pandemic. Standard setters met most recently on November 10, 2021, to consider a request for more implementation time for the lease standard, citing cited continued COVID-19 disruptions, particularly labor constraints in the labor market as well as the time and resources to comply with vital aspects of the standard. The request was ultimately rejected, citing two previous deadline extensions, and implementation of the standard is set to begin for financial statements with their year ending December 15, 2022.
For lessees, leases will either be classified as a finance lease or an operating lease. Finance leases closely resemble what was previously referred to as capital leases whereas control over the asset is transferred to the lessee. A five-step criteria exists to classify a lease as a finance lease. Operating leases, the primary reason of the standard, refers to control over the use of the asset. Provided that the contract (lease) meets the definitions of an identified asset and allows the right of control, the lessee will record two new balance sheet accounts: right-of-use asset and lease liability. Valuing the right-of-use asset involves considerations such as the calculated lease liability, initial direct costs, payments made before the lease commences less any lease incentives. In contrast, the liability is the present value of the lease payments, factoring in a discount rate specified within the lease. Amortization of the asset and liability varies as well, which creates an imbalance in ratios as the life of the lease proceeds.
Additionally, there is guidance that exists surrounding the inclusion or exclusion of non-lease components, such as common area maintenance charges and real estate taxes. There are numerous factors to consider when determining on the treatment of non-lease components, including calculation complexity and effect on the financial statements.
WHAT THIS MEANS FOR YOU
Companies with a significant number of operating leases could potentially have a large increase in assets and liabilities beginning with their financial statements ending in December 2022. For entities with existing debt covenants, it is best to calculate what effect this will have on them. We recommend communicating any adverse effects with your lending institution to consider whether amendments are necessary or if a new debt agreement is warranted.