As with any accounting standard shift, the new lease standard (ASC 842) brings momentous changes to accounting processes and financial reporting. While the main differences are well-known, I’ve taken a particular interest in the smaller nuances that live within the new standard. (Yes, I’m an accounting nerd and I love learning about and discussing all things related to leases!)
In this article, I’m sharing five of those intricacies that you may not know about the new lease standard, but that are critical to making the transition.
1. Equity likely isn’t impacted
I recently got into an argument with a potential client about this one — not the best way to start out a new relationship! And I understand where he was coming from: When changes in an accounting standard impact assets or liabilities on the books, typically the difference flows through equity. In this situation, the new lease standard is unusual in that equity is most often not impacted for initial journal entries.
Here is the correct process to follow when transitioning leases from ASC 840 to ASC 842:
- Calculate your lease liability, which is the present value of all future lease payments after the initial application date.
- Remove existing lease balances, such as deferred rent. As you reverse these balances off the books, they should flow through the right-of-use asset, not through the equity balance as is common when implementing a new accounting standard.
- In most cases, the ROU asset is the lease liability, plus or minus the difference of those existing balances.
Note: As with most rules, there are exceptions depending on policy elections and other scenarios. Find those exceptions, along with common missteps to avoid when creating initial journal entries, in here. this article.
2. Watch out for embedded leases
A trickier aspect of the new lease standard is the concept of embedded leases, which frequently occurs when an organization has a service contract where an asset is part of the value provided and the use of that asset meets the definition of a lease. Embedded leases must be treated like any other lease under the new lease standard in terms of accounting.
In order to qualify as a lease, the asset must be:
- A physical asset;
- Controlled by the lessee, meaning the organization has the right to substantially all the economic benefits and the right to direct the use of that asset during the contract term; and,
- Explicitly identified in the contract and the supplier does not have the practical ability or economic incentive to substitute out the asset
One example to consider is a service provider that does regular deliveries for your company. They have a fleet of vehicles, but one truck dedicated solely to making your deliveries. The truck is a physical asset and you receive substantially all the economic benefits of it, so it satisfies the first two conditions to qualify as a lease. However, if the supplier could easily substitute that truck, perhaps for a vehicle with better gas mileage, then the asset is not explicitly identified, and thus not an embedded lease.
3. No more prepaid or deferred rent
As we know, the major change brought about with the new lease standard is the inclusion of operating leases on the balance sheet. In the past, only items like prepaid or deferred rent were reflected on the balance sheet.
To add the operating lease to the balance sheet, you need to create an ROU asset and lease liability. Existing deferred or prepaid rent balances are netted against that ROU asset and going forward, the difference between cash and the straight line expense flow through the ROU asset.
4. Banking relationships may be impacted
Many organizations did not foresee the impact of the new lease standard on their banking relationships. It makes sense, though, particularly for companies that must comply with debt covenants for a bank loan.
Although operating lease committed future payments may have been part of the organization all along, the new lease standard now adds these as liabilities on financial statements. That means financial institutions will now have more information about the company’s lease portfolio, which can affect how the bank considers credit availability and borrowing rates. Further, depending on how debt covenants are written, some organizations may find themselves out of compliance when their operating leases are added to the balance sheet.
The best approach here is early communication with financial institutions about the potential impact of the new lease standard.
5. Lease term for related parties
Related-party transactions generally receive special scrutiny, so it was expected that the same would be true for the new lease standard. In this situation, however, the Financial Accounting Standards Board clearly states that we should treat related-party leases as we would any other lease. The biggest impact of this approach is in determining lease term and renewal periods.
Though a related-party lease may in practice have unlimited renewal periods, or other assumptions due to the fact that it is between related parties, FASB says we should apply the same logic about economic incentives as we would for any lease when looking at lease term. Get more details on that here.