Countdown to Adoption of ASC 842: Leases for Private Companies

Accounting Standards Codification 842 – Leases (ASC 842) is required to be adopted by private companies for fiscal years beginning after December 15, 2021. Entities will be required to recognize and measure leases at the beginning of the earliest period presented, using a modified retrospective approach.

As financial institutions finalize their inventory of leases and develop models using Excel or other third-party software, some key considerations include the following:

• Under ASC 842 operating leases will be recorded in the balance sheet as assets and liabilities. Current U.S. generally accepted accounting principles (U.S. GAAP) requires only capital (finance) leases to be recognized in the balance sheet. Amounts related to operating leases largely are reflected as rent expense in the income statement and in disclosures to the financial statements.
• ASC 842 requires a lessee to recognize the assets and liabilities that arise from leases (operating and finance). However, for leases with terms of 12 months or less, a lessee is permitted to make an accounting policy election not to recognize lease assets and lease liabilities. If a lessee makes this election, it should recognize lease expense for such leases generally on a straight-line basis over the lease term.
• For operating leases, a lessee is required to:
  • Recognize a right-of-use asset and a lease liability on the balance sheet, initially measured at the present value of the lease payments.
  • Recognize a single lease cost, allocated over the lease term generally on a straight-line basis.
  • Classify all cash payments within operating activities in the statement of cash flows.
• For finance leases, a lessee is required to:
  • Recognize a right-of-use asset and a lease liability on the balance sheet, initially measured at the present value of the lease payments.
  • Recognize interest on the lease liability separately from amortization of the right-of-use asset in the income statement.
• Classify in the statement of cash flows (a) repayments of the principal portion of the lease liability within financing activities and (b) payments of interest on the lease liability and variable lease payments within operating activities.

Calculate lease liability using an appropriate discount rate to determine the present value of future lease payments. This should be either (i) the rate implicit in the lease, if it can be readily determined based on the asset’s fair value or residual value at the end of the lease, plus any initial direct costs; (ii) the incremental borrowing rate that the lessee would pay to borrow on a collateralized basis over a similar term; or (iii) a risk-free discount rate (a practical expedient for private companies). The selected discount rate should be documented and supported.

Lease Term

In measuring the right-of-use asset and lease liability, the lease term should be based on the “reasonably certain” period to which the lease relates. Any optional periods or extensions should be evaluated by the company in its adoption analysis and documented accordingly.

Disclosures

When preparing financial statements, companies should closely review ASC 842’s disclosure requirements to ensure that information is accurately reflected in the balance sheet, statement of operations and cash flows, as well as the notes to the financial statements. This includes, but is not limited to:

• Recognizing the right-of-use asset and liability on the balance sheet as a separate line item, or ensuring disclosure in the notes of the amount and corresponding line item.
• Presenting a non-cash investing and financing activity item for the establishment of the right-of-use asset and lease liability at commencement, based on ASC 210-10-50-4.
• Information about the nature of leases including description, terms and conditions, variable lease factors, options to extend, and recognition considerations in measuring the lease.
• Weighted-average discount rate for the lease.
• Weighted-average remaining lease term.
• Impact of adoption on retained earnings, if applicable.
• Election of practical expedients or other policies in adoption.
• Future lease payments over next five years and thereafter, recognizing the effects of discounting and net lease liability.

Call Reports

Financial institutions should carefully review the call report instructions when adopting ASC 842 to ensure that any changes in accounting are reflected in accordance with the Federal Deposit Insurance Corporation (FDIC) requirements, including the calculation of regulatory capital.  Current guidance indicates that, to the extent a right-of-use asset arises due to a lessee’s lease of a tangible asset (e.g., building or equipment), the right-of-use asset should be treated as a tangible asset not subject to deduction from regulatory capital. Excepting institutions that have a community bank leverage ratio framework election in effect, a right-of-use asset not subject to deduction must be risk-weighted at 100 percent in accordance with the FDIC’s regulatory capital rules and included in a lessee institution’s calculations of total risk-weighted assets. In addition, a right-of-use asset must be included in a lessee institution’s total assets for leverage capital purposes.

With increases in assets and liabilities expected in the balance sheet upon adopting ASC 842 leverage ratio covenants could be impacted. Absent future change, leverage ratios based on current U.S. GAAP could be impacted, since liabilities will be increased under most definitions of liabilities in debt agreements. This could also impact:

• Debt-to-equity ratios.
• Interest coverage ratios.
• Return on assets.
• Current ratios.

Financial institutions should carefully consider loan agreement covenants with customers and determine whether modifications may be necessary to compensate for the adoption of a new accounting pronouncement.

For more information about ASC 842 and its potential impact on your business, contact your Marcum advisor.