If your organization has not already adopted lease accounting, the clock is ticking. The amendments are effective for fiscal years beginning after December 15, 2021, meaning that nonpublic companies must adopt the new rules with an effective date of January 1, 2022.
Summary of the Changes
The most significant change from existing guidance is the requirement that operating leases be recorded on the lessee’s balance sheet. There will be a new asset where the calculated present value of the lease payments will be presented called a right-of-use asset and there will also be a corresponding lease liability. The lessee should use the rate implicit in the lease as the discount rate. Alternatively, nonpublic companies can elect to use a risk-free discount rate using a period comparable to the lease term. The related expense of amortizing the right-of-use asset will be presented in one line item of the income statement as rent expense.
Another significant change with the new standard is that renewals must be taken into account when calculating the present value of lease payments. If the organization is more likely than not going to exercise a renewal, then the renewal term must also be factored in when determining the overall lease term. This may cause the balance of the right-of-use asset and lease liability to grow significantly, especially in the case of building/space rentals.
Current guidance for capital leases remains mostly unchanged except for the following:
- These leases will now be referred to as finance leases.
- There are now five criteria when determining whether a lease will be classified as a finance lease or an operating lease (only one needs to be met to classify as a finance lease):
- Ownership of the underlying asset transfers to the lessee by the end of the lease term
- An option to purchase the underlying asset exists, which the lessee is reasonably certain to exercise
- The lease term is the major part of the remaining economic life of the underlying asset (the specific 75% language was removed from the standard)
- The present value of the future stream of payments substantially exceeds the fair value of the underlying asset (the specific 90% language was removed from the standard)
- The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term
There are also enhanced disclosure requirements for all leases including specified cash flow data, the weighted-average remaining lease term and discount rate, in addition to a maturity analysis.
Lease Accounting Adoption Activities to Start Now
What should your organization be doing now to prepare for adoption? There are several activities that your organization should be undergoing at this time:
- Identify all leases (and the related lease agreements) the organization is currently a part of. Having a complete lease inventory is critical to ensuring the standard is adopted correctly and timely. This includes performing an analysis to determine whether the organization has any embedded leases within contracts.
- Determine all policy elections the organization intends to make, including whether the organization will take advantage of practical expedients. Options include:
- Lessee may elect NOT to apply the new lease accounting rules to leases with a term of 12 months or less.
- Lessee may elect to combine lease and nonlease components as a single lease component. Keep in mind that if this practical expedient is used, the right-of-use asset and corresponding lease liability will be higher than if only the lease component is included.
- As mentioned previously, lessees may elect to use the risk-free rate in lieu of determining an incremental borrowing rate for each lease.
- Lessee may elect to define the “major part” of the economic life of an asset to be 75% and may elect to define “substantially all” as 90% when evaluating the classification of a lease between finance and operating.
- Lessee may elect to adopt the standard only in the current period without having to go back and restate prior years of financial data. Any cumulative adjustment would be booked to retained earnings in the year of adoption.
- Lessees may elect to not reassess the lease classification upon adoption of this standard, meaning that an operating lease remains an operating lease and a finance lease remains a finance lease.
- Decide how the organization will be performing these calculations – use a software provider or calculate manually.
- Determine whether any current lending arrangements need to be altered, including debt covenants as a result of adopting the new standard.