Nonpublic companies have been given an additional year to implement the new lease accounting standard (FASB ASC 842). Most private companies will now need to include the effects of the new standard and its related disclosures in their December 31, 2021 financial statements. All interim financials after that date would also include the effects of the new standard.
This reporting relief was welcomed by many, but that does not mean it’s a good idea to wait until the end of this extended period to determine your implementation strategy.
The standard’s most significant impact is the requirement to recognize assets and liabilities for the majority of operating leases. Companies with a significant amount of operating leases or leases with longer terms will see a significant balance sheet impact, because the present value of future payments under those leases will be recorded as a long-term asset as well as both a current and long-term liability. As a result, the standard will have an impact on certain financial statement ratios, such as liquidity ratios and leverage ratios. There will be minimal impact to net income and cash flows.
Here is a list of implementation recommendations and considerations:
1. Develop an implementation strategy.
- Identify available resources and a champion for the project.
- Evaluate existing leases and service agreements to identify all operating leases and finance leases.
- Evaluate software considerations.
- Consider accounting policy elections, including available practical expedients. Some examples include:
- Waiver of classification reassessment of active leases
- Exclude leases of 12 months or less (short-term lease)
- For private companies, the risk-free interest rate can be used instead of the incremental borrowing rate
- The potential elimination of the need to separate non-lease components from lease components
- Determine transition year financial statement presentation.
- Recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach; or
- Treat as a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption.
2. Evaluate terms for new leases and upcoming lease renewals.
- Consider whether terms can or should be modified to change the accounting treatment.
3. Determine the impact to the balance sheet and financial ratios.
- Accumulate information about the cash flows associated with all of your leases.
- Perform a present value calculation of the future payments.
- Pro-forma financial statements to show effect.
4. Evaluate third-party agreements, such as those with banks or others that have clauses related to the balance sheet.
- Determine if changes in financial reporting impact financial covenants.
5. Communicate with impacted third parties.
- Customers should work with bankers to make sure changes resulting from the new accounting treatment do not cause customers to be in violation of financial covenants.
- Communicating with your banker and others about the impact prior to full adoption is highly recommended. This will provide you with the opportunity for both parties to confirm agreement regarding how they will treat the changes.
If you start working on lease accounting implementation now, you will have a better understanding of the financial statement impact as well as more time to evaluate and update your internal controls, systems, and processes. It will also provide a greater opportunity to modify and negotiate agreements with third parties to ensure that the provisions of those agreements are favorable to the company.
This article is the first in a three-part series on the new lease accounting standard that we’ll be publishing in 2020. Stay tuned for part two in the series in late spring, where we’ll discuss the financial statement impact of the standard. Part three in the fall will answer some frequently asked questions we’ve been receiving from our clients as they work to implement the new standard. As always, if at any time you have any questions or would like to discuss the potential impact of the new standard on your business, please don’t hesitate to contact us.
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