Implementing the New Lease Standard

By Katie Dauenbaugh

Start the implementation process

The implementation date of the new lease standard ASC 842 for private companies is fiscal years beginning after December 15, 2021.

The primary effects of the new lease standard as it relates to lessees are as follows:

  • Operating leases, which were historically “off books” will now be recorded on the balance sheet, through the creation of a right-of-use asset (“ROU”) and lease liability, and the concept of deferred rent is eliminated.
  • Capital leases become finance leases.

Calculating ROU assets and liabilities can be complex. Companies will need to exercise care and judgment when evaluating contracts and agreements that may include a lease.

What is a lease?

As defined in the standard: a lease is a contract, or part of a contract, that conveys the right to control the use of identified property, plant or equipment for a period of time in exchange for consideration.

Easy to identify leases are standard office leases and equipment leases. Other contracts that may include a lease are telephone and/or internet agreements (such as cloud arrangements or other IT contracts) and office or vending machine agreements.

It is important to differentiate between service contracts and leases. In typical service contracts, the customer obtains economic benefits from the service only as the vendor performs the service within the contract. In a lease, the lessor delivers the asset to the lessee and the lessee now controls that asset and has created an obligation to pay for the right-of-use asset. Some arrangements may include embedded leases (for example: the company pays for supplies, but the vendor supplies the machine).

Types of leases

Once a lease is identified, it is categorized as either a finance lease, an operating lease, or a short-term lease.

  • Finance leases (formerly capital leases).
  • The criteria to record as a finance lease include the following:

    • Lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
    • Lease contains a purchase option that the lessee is reasonably certain to exercise.
    • The lease term is for the major part of the remaining economic life of the underlying asset.
    • The present value of the lease payments and residual value guaranteed by the lessee equals or exceeds substantially all the fair value of the underlying asset.
    • The underlying asset is specialized and expected to have no alternative use to the lessor at the end of the lease term.
  • Operating leases - the primary change is in the measurement and recognition of the right-of-use asset and lease liability.
  • Short term leases are those with a lease term of 12 months or less. They cannot include potential extensions. They cannot include an option to purchase the asset that a lessee is reasonably certain to exercise. Any leasehold improvements acquired as part of the lease would be expensed at the end of the initial term.

What about those month-to-month related party leases?

A common situation for private companies is for the company to lease office space from a related party (the owner) on a month-to-month lease. This arrangement will most likely need to be modified under the new standard. If the lease can properly be classified as a short-term lease (there is no expectation that the business will exist at the location in the following month), all leasehold improvements would need to be expensed in the month acquired as the lease term ends at the end of the month. However, if the business has existed at that location for many years, the history would be evaluated and would impact the determination of the lease classification. In most scenarios, the result would be the lease classified as an operating lease and the creation of a ROU asset and liability.

Identify all the lease components

Initial asset measurement

At the commencement of a lease, an entity should first determine its total lease payments. Total lease payments should include fixed payments, variable payments, the exercise price of a reasonably certain option to purchase the underlying asset, and amounts guaranteed under a residual value guarantee. Payments for terminating the lease, if the lease term includes a lessee option to terminate the lease, should reduce the total lease payments. Total lease payments do not include real estate taxes, building insurance, or lease payments determined based on a percentage of sales of the lessee.

In determining when to record ROU assets created by leases, the Company should carefully consider a threshold so as to not understate liabilities.

Initial lease term

The lease term should be the non-cancelable period of the lease along with any periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option, as well as any periods covered by options to extend or terminate that would be controlled only by the lessor.

Lease liability

The lease liability is the present value of the lease payments not yet paid, discounted using the discount rate for the lease.

The discount rate should be the entity’s incremental borrowing rate. However, private companies may use the risk-free discount rate for a comparable lease term. If the risk-free rate option is selected, it must be used for all leases.

Right-of-use asset

Generally, the right-of-use asset is the amount of the lease liability plus initial direct costs and prepaid lease payments, less any lease incentives received.

Initial direct costs are those costs that would not have been incurred if the lease had not been obtained. This includes commissions paid.

Accounting requirements

Summary based on lease classification

Finance Leases Operating Leases
ROU Asset Lease Liability ROU Asset Lease Liability
Balance Sheet
Initially measured at the amount of the lease liability, plus initial direct costs and prepaid lease payments, less any incentives received. Initially measured at the present value of the unpaid lease payments Same initial measurement as finance leases
Subsequently, amortized on a SL basis to earlier of the end of its useful life or lease term Subsequently, increased to reflect interest using the interest method and decreased by lease payments Amortize based on the difference between periodic SL lease cost (inl amortization of intital direct costs) and periodic interest accretion. Same as finance lease.
Income Statement
Recognize amortization of ROU asset Recognize a single lease cost generally on a SL basis
Recognize interest on lease liability Recognize variable lease payments not included in the lease liability when incurred, and
Recognize variable lease payments not included in lease liability when incurred and Recognize impairment loss if any

How is the standard implemented in the year of transition?

In the year of transition Companies have the following options with regard to existing leases; allows companies to not reassess whether any expired or existing contracts are or did contain leases; to not reassess the lease classification for any expired or existing leases; and to not reassess the initial direct costs for any leases. In other words, if the agreement was previously considered an operating lease, it’s still an operating lease and if it was a capital lease, it is now a finance lease. If an existing agreement was not considered a lease under the prior standard, it is not considered a lease under the new standard. However, once the existing agreements expire, all new agreements will be re-evaluated and classified in accordance with the new lease standard.

Companies will then generally calculate the related journal entries based on classification of lease (See “Accounting requirements” table) at the time of implementation, and record the related assets and liabilities, with an adjustment to retained earnings.

How do we do this?

There are several considerations when determining how to perform the calculations for the right-of-use assets and liabilities.

There are certain specialized software programs on the market which will perform the calculations for the ROU assets, lease liabilities and expense values for each year as well as calculate and prepare the disclosures required for the footnotes.

We recommend you consider using software, however manual calculations in excel are also an option. Lease software provides the ability to calculate multiple leases as well as the flexibility to enter the necessary modifications as they arise. The programs not only calculate the balance statement balances but also calculate the quantitative information required for the footnotes. The additional bonus to selecting a third-party software package is that the auditors will be able to rely on the work of the outside specialist. This will reduce audit time associated with the lease standard implementation.