After years of notice and months of COVID-related delays, the effective date of ASC 842, the new lease accounting standard, is almost here for private companies. To help your construction company prepare, Jake Kurz, CPA and James Martin of Grassi’s Construction Group answer some of the most commonly asked questions and provide practical tips for using the final weeks of 2021 to get ready for compliance.
What is ASC 842? The new lease accounting standard (ASC 842) was published by the Financial Accounting Standards Board (FASB) and requires the tracking and disclosure of all real property leased by a company.
When does this accounting standard take effect? Private companies will need to adopt this new standard for fiscal years beginning after December 15, 2021 and interim periods beginning after December 15, 2022.
How is the new standard different from how I am already accounting for leases on my balance sheet? The prior accounting standard (ASC 840) only required capital leases to be included on the balance sheet. ASC 842 keeps the same two-model lease classification but requires most off-balance-sheet leases, regardless of classification type, to be recorded on the balance sheet. Going forward there will be a long-term asset offset by a current liability and a long-term liability. By requiring this, FASB is aiming for better transparency into the financial positions of companies.
Are there any exceptions to the standard? A lessee may elect, as an accounting policy, not to record leases with terms of 12 months or less on the balance sheet.
Is there an impact on my company’s income statement? While both operating and finance leases will be recorded on the balance sheet, expense recognition is different. Operating leases will require lease expense to be recognized on a straight-line basis over the lease term. Finance leases will require the lessee to recognize interest expense and amortization expense. As a result, the lessee will usually recognize a greater expense earlier in the life of finance leases.
What qualifies as a lease? A lease is a contract that gives a customer the right to control the use of an identified asset for a period of time in exchange for consideration. Control is considered to exist if both of the following criteria are met: 1) the customer has the right to obtain substantially all of the economic benefits from use of an identified asset, and 2) the underlying asset is not highly dependent on or highly interrelated with other assets in the arrangement. Common types of leases include, but are not limited to: corporate offices, office equipment, job site trailers, vehicles, software and construction equipment.
What about related party leases?
Under ASC 842, leases with related parties should be treated in the same manner as leases with unrelated parties. According to ASC 842-10-55-12, these leases “should be classified in accordance with the lease classification criteria applicable to all other leases on the basis of the legally enforceable terms and conditions of the lease.” These types of transactions are not always sufficiently documented, and terms and conditions may not be at arm’s length. As a result, it is imperative to consider all factors that may result in legally enforceable rights and obligations. It cannot be assumed that a lease would not need to be considered if the terms are not formally documented, because unwritten terms can create enforceable rights and obligations. Regardless of whether related party arrangements are recognized and measured on the balance sheet, all lessees and lessors must comply with the Related Party Disclosures requirement under ASC 850.
How do I implement this transition? Follow these basic steps to transition from your current accounting procedures to the new standard:
- Determine the lease term under ASC 840.
- Determine total lease payments under GAAP.
- Prepare straight-line amortization schedule under ASC 840.
- On the effective date of ASC 842, determine total payments over the remaining lease term under the new lease accounting standard.
- Calculate the operating lease liability (present value of the remaining lease payments).
- Calculate the right of use (ROU) asset and book the corresponding journal entry to record the ROU asset and lease liability at transition.
- After recording the journal entry, prepare an amortization table under ASC 842 to help with entries that will need to be made moving forward.
Are there any changes to lessee disclosures? ASC 842 expands lease disclosure requirements, which companies should consider early on in the implementation phase to ensure they are fully prepared. Disclosure requirements include: nature of leases, information about leases that have not yet commenced, related-party lease transactions, accounting policy election regarding short-term leases, finance and operating lease costs, short-term and variable lease costs, gain or loss from sale-and-leaseback, maturity analysis for lease obligations, weighted-average remaining lease term, and weighted-average discount rate.
How can I proactively prepare for compliance? With the effective date of ASC 842 quickly approaching, take the time now to follow these proactive steps and prepare for a successful transition:
- Build an inventory of your leases – Start building a lease schedule that tracks lease terms, lease payments, incremental borrowing rates, etc. Separate leases between operating and financing leases.
- Identify embedded leases – In addition to typical leases, there may be embedded leases in your contracts that you are not aware of. For example, if a service contractor provides equipment that you control (e.g. IT equipment or automobile) as part of the service contract, that portion of the agreement may be considered a lease.
- Determine how to account for each lease – Determining how to account for your leases can be tricky and time-consuming. Talk to your Grassi advisor about how to assess the proper accounting treatment.
- Consider the benefits of practical expedients – FASB allows for certain practical expedients such as exemption of short-term leases (12 months or less).
- Start conversations with your lenders – It is important to have talks with your banks, bonding agencies, sureties, and/or other lenders in order to discuss the potential impact on certain financial covenants/ratios to account for the new burden that will be placed on your balance sheet
- Talk to your advisor – The new rules for ASC 842 are fairly straightforward, but there are many factors to consider such as contract modifications, remeasurement requirements, non-lease components and more. Talk to your CPA to ensure you are properly accounting for this new standard.
- Explore available software packages – There are a number of software packages available to help simplify the process of complying with ASC 842. Features range from automation of preparation of schedules and reconciliations to simple and efficient generation of reports needed for disclosures.
The construction industry, with its wide variety of operating and financing leases, will be especially impacted by the new lease accounting standard. Save valuable time and compliance risk by understanding and implementing the basic elements of a successful transition. For more information and assistance, please contact your Grassi advisor or one of Grassi’s Construction professionals.