March 1, 2022 by Daniel K. Fredrickson, CPA
In February 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02, which created Accounting Standards Codification (ASC) Section 842, Leases (“ASC 842”). This new standard provides significant updated guidance for how non-public business entities account for operating and capital leases.
The most significant impacts from the new accounting guidance are described as follows:
- Previously, businesses were permitted to disclose the present value of future lease payments on any leased assets in the financial statement footnotes, generally with little balance sheet impact; under ASC 842, businesses will now be required to recognize “Right-of-use” (“ROU”) assets and liabilities for all leases with lease terms greater than 12 months, directly impacting the balance sheet.
- Leases will now be classified as either “Operating” or “Finance”. Operating leases include most leases of property, similar to how they are currently considered. Finance leases generally encompass leases that were previously considered “capital” leases and include leases of most assets other than property. The factors to consider in determining how to classify leases as operating or finance remain similar to current U.S. GAAP.
- For operating leases, businesses will be required to establish an ROU asset and lease liability that will be initially measured at the present value of future lease payments. The lease liability will be expensed on a straight-line basis, and all lease payments will be classified as operating activities on the statement of cash flows.
- For finance leases, businesses will be required to establish an ROU asset and lease liability that will be initially measured at the present value of future lease payments, similar to operating leases. However, the ROU asset will be amortized, and interest expense on the liability will be recognized using the effective interest rate method. In addition, on the statement of cash flows, lease payments will be reported showing a “principal” portion classified as a financing activity and an “interest” portion as an operating activity.
- The definition of a lease itself has changed to include any provision in a contract that establishes a leased asset. For many businesses, this will mean additional time spent reviewing contracts with suppliers to determine whether any provision of the contract contains a lease that will need to be recognized on the financial statements.
- The recognition of ROU assets and liabilities is likely to impact debt covenant calculations. Therefore, it is very important that businesses calculate these assets and liabilities correctly and determine the impact they will have on these calculations so they can be prepared to make any modifications to loan agreements, if necessary.
For nonpublic businesses, ASC 842 will go into effect for fiscal years beginning after December 15, 2021, so businesses will need to prepare to implement the new standard for the year ending December 31, 2022, or any short periods ending in 2022.
Please contact your Bronswick Benjamin trusted advisor if you need assistance in identifying your lease obligations and preparing the necessary calculations to comply with this complex standard!
The above is general information regarding ASC 842 and is not intended to apply to specific leases or circumstances.