There are new accounting rules in effect for leases which are required for years ending December 31, 2022 and later. If you have leases for facilities, vehicles and/or equipment, you will need to adopt FASB Topic 842, which requires reporting of both a right-of-use (ROU) asset and a lease liability, for all leases with an initial term of more than one year. Historically, this was only done for capital leases, which will now be referred to as finance leases. This is the first significant change to lease accounting rules since the Financial Accounting Standards Board (FASB) adopted Statement Number 13 in 1976. As with any change of this magnitude, adequate planning and preparation are necessary, and in many cases, internal resources can become overwhelmed. In fact, many entities are underestimating the level of effort, complexity, resource requirements and timeline for adoption. Depending on the size and complexity of the lease portfolio, this can become a significant project.
Lease accounting compliance is not a one-size-fits-all process but there are some common steps that you can take to make sure you are heading down the right path. Getting the right support to assist you in making the transition is key.
- Collect data and assess lease portfolio. Determine what kind of leases you have and where the information is located.
- Summarize all your leases (payment streams, terms, etc.) Determine the lease term to be used, which could include renewal option terms if there is a significant economic loss that would be incurred by not renewing the lease. Also, if equipment maintenance is included in the monthly lease payment, you can elect not to separate this if it is not easily identifiable.
- Determine the proper classification for each lease, either financing or operating. You can use a practical expedient which allows you to retain the prior classification for all leases in place prior to the adoption of this pronouncement, so capital leases would become financing leases and operating leases would remain as such.
- Weigh the impact – Do you have an implementation plan? How will your balance sheet be affected by this change? How will key financial ratios and loan covenants be affected? Evaluate your technology needs – Do you have a significant number of leases? Is it cumbersome to track them? Could lease tracking software simplify the process? Does the technology benefit justify the cost?
- Select a solution, which could include the purchase of a software package, development of a spreadsheet application, or utilizing the resources of Lear & Pannepacker to assist with the computations. Which path is right for you? Consider several key factors, including:
- The number of leases in your lease portfolio, as well as the dynamic nature and complexity of your leases
- Economic value and overall materiality of your leases
- Your existing level of technical accounting expertise and knowledge of lease accounting
- Capacity of resources within your organization for initial adoption and ongoing lease accounting
- Your existing technology environment and solutions to support lease accounting
If you currently have a deferred rent liability (or asset), this will become part of the lease liability calculation under Topic 842. There are certain options available to non-public companies and not-for-profit entities in performing the computation of the ROU assets and lease liabilities, which we can help you to understand. You will need to determine the effective interest rate that will be used in computing the asset and liability. For financing leases (currently referred to as capital leases), an explicit rate must be used. For all operating leases, a risk-free rate of return is an easy option for most entities, but using your effective borrowing rate will produce a smaller liability. Once you have completed the summary, we can assist you with determining your effective interest rate and prepare the required calculations and required disclosures. We recommend that you start this process as soon as possible, to provide an opportunity to see how this will impact your financial statements and financial ratios before the year-end close.
As these changes will only impact your balance sheet and will not affect your net income, there are no income tax implications of this accounting change. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied upon for tax, legal, or accounting advice. If you have any questions about lease accounting or adopting FASB Topic 842, please do not hesitate to contact us at Lear & Pannepacker.