New Lease Accounting Standard (ASC 842)

Nagano Morita a Division of Prager Metis CPAs
Issued on December 9, 2021



The New Lease Accounting Standard

For all private nonpublic companies using U.S. GAAP, the new lease accounting standards ASC 842 will take in effect for fiscal years beginning after December 15, 2021.  This means that for calendar year ending companies, the adoption date will be January 1, 2022. This change will have a significant impact on the financial statement accounting for leases by lessees, in that virtually ALL leases will be included on the balance sheet.


Overview of the Standard

Current U.S GAAP (ASC 840) specifies that only prop­erty, plant, or equipment (which includes only land and depreciable assets) can be the subject of a lease. The new guidance specifically states that leases of right-of-use assets in a sublease are in scope. The following, however, are excluded from the scope of the leasing guidance:

  • Leases of intangible assets;
  • Leases to explore for or use minerals, oil, natural gas, and similar non-regenerative resources;
  • Leases of biological assets, including timber;
  • Leases of inventory; and
  • Leases of assets under construction.

Lessee:

Under the new guidance, lessees will need to recognize a right-of-use asset (an asset that represents the lessee’s right to use an underly­ing asset for the lease term) and a lease liability (a lessee‘s obligation to make lease payments arising from a lease, measured on a discounted basis) on the balance sheet for virtually all leases (with the exception of leases that are classified as short-term). Short –term is defined as a lease that has a lease term of 12 months or less at the commencement date and does not contain an option to purchase the underlying asset that the lessee is reasonably certain to exercise.

Leases should be classified as operating or finance.  Operating leases will result in straight line expense (similar to current operating leases) and finance leases will result in a front-loaded expense pattern (similar to current capital leases).  Classification is largely the same as the criteria used in the existing guidance, but without the explicit bright lines.

Lessor:

The model for lessor accounting in ASC 842 will be substantially similar to the current model, but updated to align with certain changes to the lessee model (i.e. certain definitions, such as initial direct costs, have been updated) and the new revenue recognition standard. Similar to current guidance, lessors will classify leases as operating, direct financing, or sales-type.

Lease accounting will continue to require significant judgments, including when making estimates related to the lease term, lease payments, and discount rate. Similar to today, the term of the lease will include the non-cancellable lease term plus renewal periods that are reasonably certain of exercise by the lessee or within the control of the lessor.

Leveraged lease accounting has been eliminated, although it has been grandfathered for existing arrangements.


Steps of adoption (Lessee):


1. Identify Lease

Lease is “a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.”

Need to meet the following conditions:

  • There must be a physical identified asset.
  • The lessee has the right to control the use of the identified asset.
  • The lessee is able to receive the economic benefits from the asst. 

2. Identify Lease Term

Lease term is a noncancellable period for which the lessee has the right to use the underlying asset, adjusted for:

  • Extension or renewal period if lessee is reasonably certain to extend
  • Lease termination options if lessee is reasonably certain to exercise (or not exercise)
  • Assume that lessor will trigger the extension or renewal option
  • Also assume that lessor will choose to not terminate the lease


3. Determine Lease Payments

Lease payments including

  • In-substance fixed payments
  • Variable payments like Common Area Maintenance fees are NOT included

 

4. Calculate Discount Rate

  • Use rate implicit in the lease, but if that cannot be readily determined, use Lessee’s incremental borrowing rate
  • Incremental borrowing rate equals what a lessee would have to pay for a collateralized borrowing over a similar term as the lease
  • Nonpublic business entity may elect to use a risk-free discount rate for all leases

 

5. Classify The Lease

A lease that meets any of these criteria is a Finance Lease:

  • Ownership transfers to lessee by end of lease
  • Lessee is reasonably certain to exercise option to purchase the asset
  • Lease term is for major part of asset’s remaining economic life
  • PV (lease payments + incremental residual value guaranteed by lessee) > substantially all of the FV of asset
  • Asset will have no alternative use to lessor at end of lease

A lease that meets none of these criteria is an Operating Lease.


6. Initial measurement and recognition
a. Day1 Journal entry for all leases (Finance Lease and Operating Lease)

   

Dr) Right of Use (ROU) Asset        $ xxx

Cr) Lease Liability          $ xxx

 

 

“Lease Liability”

Present Value of lease payments not yet made, discounted at:

  • Implicit rate in the lease, or
  • Lessee’s incremental borrowing rate if implicit rate in the lease is not readily determinable, or
  • Risk-free discount rate using practical expedient election (Nonpublic companies only)

 

“Right of Use (ROU) Asset”

 

Lease liability on Day 1, adjusted for:

 

      +Initial direct costs incurred by the lessee

      +Prepayments of lease payments

       -Receipts of lease incentives

 

b. Monthly Journal entry for Finance Lease



c. Monthly Journal entry for Operating Lease


Summary

The transition to the new standard can be challenging especially for lessees. The Company needs to evaluate and assess all the impact from this change. We would highly recommend preparing in the early stages to make sure to adopt this new standard properly.


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Nagano Morita, a Division of Prager Metis CPAs