Implementation of the long-awaited lease standard is rapidly approaching. This standard will require an organization to “capitalize” all material leases, including operating leases.
Public entities, which include not-for-profit entities with conduit debt, will implement the standard with calendar 2019 or fiscal 2020 year-end financial statements. All other entities will be required to implement this standard with calendar 2020 and fiscal 2021 year-end financial statements. An organization may elect to early adopt the new rules.
What are your options?
In the transition year, organizations have a few options on how they will adopt the new lease rules. It is important to understand the options and decide which approach your organization will take to make this transition as smooth as possible.
In the year the standard is adopted, organizations have the option to follow a full retrospective or modified retrospective approach. Either approach includes a number of optional practical expedients that we expect most organizations will elect to apply.
One of the practical expedients allows the organization to continue to classify operating leases as operating leases and capital leases as financing leases. The practical expedients, unfortunately, still require the organization to record a right-of-use asset and lease liability for all operating leases based on the present value of the remaining minimum rental payments. Calculation of the right-of-use asset and lease liability for leases currently accounted for as operating leases could be extremely time consuming and complicated depending on the volume of leases an organization has.
In the months leading up to adoption, organizations should do the following:
- Identify all leases. Under ASC 842, a lease is defined as 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;
- Determine if each lease is considered to be an operating lease or a finance lease. A finance lease is one that meets any of the following five criteria:
- Transfer of ownership at end of lease term;
- Option to purchase is reasonably certain to be exercised;
- Lease term is a major part of the economic life of the asset;
- Present value of the lease payments is substantially all of the fair value of the asset; or
- The asset is of a specialized nature—there is no alternative use to the lessor;
- Calculate the right-of-use asset and lease liability. Under the new standard, this now applies to all leases; and
- Evaluate the effect that recording these leases will have to the users of your organization’s financial statements. Consider proactively contacting lenders to discuss the impact on financial covenants.
For many organizations, there will be many leases on the statement of financial position that have never been recorded before. This will have a material effect on the organization’s statement of financial position. This could interfere with debt ratios and cause confusion for lenders, funders and the board of directors. The earlier the impact is determined, the smoother the transition process will be.