1. Understand the ASC 842 Lease Accounting Standard and Its Implications
Understanding the principles of ASC 842 is something we often emphasize. By understanding why the standard was first introduced, and how it deals with many lease-related issues, you’ll be in an excellent position to implement it. Too many companies were using off-balance sheet financing to present an inaccurate picture of their financial reality, often with the use of leases. For example, a company might want to buy a new machine, but doing so outright would drive key ratios such as the debt-to-equity ratio over a predetermined level, and trigger creditors to call in loans.
So instead of borrowing the money – increasing liabilities on the balance sheet and negatively affecting financial ratios, the company sets up a Special Purpose Vehicle (SPV) which buys the asset and then leases it back to the company. Voila! No liability, just an expense through the income statement.
One of the most infamous off-balance sheet financing cases was the multi-billion dollar implosion of Enron.
All of this was possible and in many cases legal, until Sarbanes-Oxley, IFRS 16, and ASC 842 put a stop to it.
While ASC 842 was initially delayed, it’s now crunch time as the Standard – or “Topic 842” as it’s also called – is effective for annual reporting periods beginning after December 15, 2021 (even though it can already be adopted). With the Standard becoming applicable, companies are going to have to ensure they’re prepared for the changes ASC 842 brings.
This means first and foremost understanding the essence of ASC 842, and the changes that it requires both in general approach and practical implementation.
Some key elements of ASC 842 to note:
- A lessee shall recognize all leases with a term greater than 12 months on its balance sheet
- The definition of a lease including the key concept of “control” of an asset
- Treatment of leases in terms of initial and subsequent measurement, and disclosure
- Specifically the initial creation of a lease asset (a “right-of-use” asset or ROU) and liability, the present value of lease payments and the correct discount rate to use
- The implication of “reasonably certain” lease renewals and purchase options
- Disclosure requirements (both qualitative and quantitative) including discussions of the leases, significant judgments made, information on lease-related costs in the Income Statement and analysis of discount rates used
While these are important elements, they are of course not a substitution for the full text of FASB ASC 842. That’s why Step 1 of the checklist is all about familiarity with the Standard. For helpful and more detailed references, check out guidelines produced by the Big 4 accounting firms.
Two transition methods are available: beginning of earliest comparative period affected, or the effective date. In terms of these transition methods, a great example is Apple who delineated their transition method chosen, and its impact.
In its annual report, under “recently adopted accounting pronouncements”, the company stated: “At the beginning of the first quarter of 2020, the Company adopted the Financial Accounting Standards Board’s (the “FASB”) Accounting Standards Update (“ASU”) No. 2016- 02, Leases (Topic 842) (“ASU 2016-02”), and additional ASUs issued to clarify and update the guidance in ASU 2016-02 (collectively, the “new leases standard”), which modifies lease accounting for lessees to increase transparency and comparability by recording lease assets and liabilities for information about leasing arrangements. The Company adopted the new leases standard transition method, under which amounts in prior periods presented were not restated. For adoption, the Company elected to not reassess (i) whether any are or contain leases, (ii) lease costs. Upon adoption, the Company recorded $7.5 billion of right-of-use (“ROU”) assets and Condensed Consolidated Balance Sheet.” (emphasis added)
The practical implications of these changes in dealing with leases are that all contracts have to be re-assessed in light of the requirements of ASC 842.
2. Assess All Contracts for Lease Elements
This is one of the toughest parts of implementing ASC 842. Leases, under the definition of the Standard, can be present everywhere, and are often among the first elements to be affected by business decisions.
For example, during and after the COVID-19 pandemic, many businesses downsized their real estate footprint, or modified existing agreements. While taken as a business decision, this directly impacts the accounting treatment of leases.
This type of example shows how prevalent and indeed central leases are to any organization’s operations, and how all areas can be affected. In IT it might be servers and other equipment, for Operations it might be specific machines, or service contracts.
Another important element to consider is your organization’s migration to the cloud. If it has migrated recently or is planning to do so in the near future, you should consider the implications of ASC 842 along with ASC 350 “Intangibles– Goodwill and Other” and look at how you can most effectively structure such arrangements from both a business and accounting perspective.
One element that is commonly missed is an embedded lease. An embedded lease occurs within a contract where in actuality there is a lease agreement, even though the word or concept “lease” might not appear.
Questions to ask in order to ascertain if there might be an embedded lease within the contract include:
- Does the contract refer to the use of a specific asset? (Note that this has to be a named, specific asset)
- Can the supplier of the asset substitute it with a different asset?
- Control: this is key area for defining an asset; does the organization in
question control the asset or have a right to control the asset?
Terms that may help to look out for within contracts are “exclusive use,” “sole use,” or identifiers like “Machine 2451.”
Essentially across all business units, contracts have to be re-examined to see if elements fall under ASC 842.
Doing this manually can be daunting. An organization can have hundreds if not thousands of contracts, in a combination of PDF and Excel spreadsheet formats. That’s why the software you choose to manage your lease accounting is going to be critical.
But before we talk about technology, let’s talk about people.
3. Ensure Your People are Ready for ASC 842 Financial Reporting
ASC 842 compliance is going to require not only the commitment of the finance team, but will be best served by ensuring everyone is on the same page across the organization.
We know, it can be notoriously difficult to get other departments to think about things like accounting compliance (just try getting invoices from them!)
With that being said, communicating effectively with the people in your organization will pay dividends.
You need to be informed when new contracts are entered into, have a list of existing contracts, be informed when conditions within contracts change (for example an early payback), or when contracts are canceled.
Specific attention needs to be paid to conditions where a contract is for under 12 months (and therefore not required to be recognized under ASC 842) but where renewal is reasonably certain – thus bringing the lease within the purview of ASC 842. Additionally, your asset registers or lists should be constantly checked for additions or deletions, and their effects from a lease perspective.
We recommend implementing training programs for the finance team, and where practicable, other key company employees. Having “allies” trained in the details of the new Standard will ensure that issues pertaining to leases are more likely to be picked up early.
Similarly, it will be critical to put processes and internal controls in place to ensure that leases are being dealt with correctly and effectively throughout the organization.
This seems like a lot of work, we know. The next step is all about leveraging technology to ensure full ASC 842 compliance.