After almost 40 years the Financial Account Standards Board (FASB) has replaced the Accounting Standards Codification (ASC) surrounding the leasing of property. The new standard, commonly referred to as ASC 842 or ASU 2016-02, replaces the prior US GAAP leasing standard, referred to as ASC 840.
FASB issued this Accounting Standards Update (ASU) – in February 2016 – in an effort to prevent companies from using leases as a business expense in order to make their balance sheets look ‘prettier,’ therefore boosting their likelihood of securing any necessary loans or a larger rent. This has often worked as an incentive, with businesses opting to lease rental space rather than buy properties. But under the new law things are looking very different.
The New Standard
Whereas ASC 840 allowed businesses to report only finance (capital) leases, with operating leases listed merely as a footnote in their financial statements, ASC 842 requires that most leases (including operating leases) are capitalized on the balance sheet.
The only leases allowed exemption from this new rule are short-term leases – those less than or equal to just 12 months. Lessors are required to classify a lease when it begins as one of the following types of leases based on the standard’s classification criteria:
- Sales-type lease;
- Direct financing lease; or
- Operating lease.
The criteria in ASC 842 will not make an impact on the classification of most leases. Additionally, the way in which cash flow and expenses are recognized will continue to be based upon the lease’s classification as either a finance or operating lease.
The new code also provides guidelines for what constitutes a lease, since businesses must now determine whether a contract contains a lease when it is signed into effect.
A contract is considered a lease if it provides the lessee with the right to control the use of the property (equipment, etc.) for a period of time when money (consideration) has been exchanged. But how can you determine if a business does in fact have control over the property? Control exists if you meet two requirements:
- Your business has the “right to obtain substantially all of the economic benefits from use of an asset;” and
- Your business has the “right to direct the use of that asset.”
Under the US GAAP standard, the lessee only has to meet the first requirement, but under the new standard, ASC 842, the second requirement is determined by the business itself.
Some types of assets are excluded from the new standard: inventory, some natural resources, and intangibles.
So What Does this Mean?
ASC 842 now requires that renters maintain their entire lease as a liability based on the lease’s present value of future payments. The present value is to be determined based upon the implicit rate stated in the lease or the lessee’s borrowing rate.
Because these renters don’t have an asset to cover their lease, this will skew the ratio on the balance sheet of business lenders, making it much harder to obtain their needed loans. Assets will increase, as will liabilities. Generally right-of-use assets will be recorded on the balance sheet as well as the correlated liability of the lease.
Finance leases – the lessee must identify both the interest expense as well as the amortization expense. This will result in a greater expense towards the beginning of this type of lease.
Operating leases – the lessee must identify the expense of the lease on a straight-line basis over the duration of the lease.
Public companies began implementing the new standard on December 15, 2018, while private companies will do the same on December 15, 2020. Businesses will be able to transition to this new standard at the earliest period possible and through comparative periods in the business’ financial statements.
This new lease accounting standard is expected to bring in $3 trillion of lease liability and helps to align the lessor model with the underlying principles in the FASB’s new revenue recognition standard, ASC 606.
Calculating Destiny, LLC Can Help
At Calculating Destiny, LLC, our team of knowledgeable and experienced professionals is dedicated to helping you to minimize your liabilities and maximize your assets. We have a deep understanding of the way in which the new standard ASC 842 can and will impact business leases going forward. It is our goal to work with you and your team – both on location and remotely – to optimize your balance sheet in order to help you succeed.
To learn more about how we can help to put your business back on track for financial success, schedule a free consultation by visiting us online or calling us at 215-674-3430 today!