Lease Accounting for Small Businesses – Five Things to Help You Have a Timely Year-End Close
With year-end 2022 fast approaching, start planning now for implementation of the new lease standard, Accounting Standards Codification (ASC) 842. FASB released this standard to replace ASC 840 for all businesses that follow GAAP. Because the new standard requires all leases to be considered for capitalization, this has the potential to significantly impact the balance sheets of small businesses. Therefore, it’s important to understand how the change affects your business and how to start planning so you can have a timely and successful year-end close. Here are five actions to help you:
Determine if the New Lease Standard Applies to Your Business
Only businesses that prepare their financial statements in accordance with GAAP are required to adopt ASC 842. Private businesses must adopt the standard for fiscal years beginning after December 15, 2021 (calendar year 2022). In addition, only leases that have terms longer than 12 months have the standard applied.
Determine What Qualifies as a Lease Under ASC 842
The definition of a lease in ASC 842 is “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.” The control of the asset means that the lessee has both the right to obtain substantially all the economic benefits from the use of the asset, and the right to direct the use of the asset. Leased assets can include vehicles, office equipment, buildings, and service agreements. This determination will require a thorough review of all expenses, assets, and contracts.
Gather the Required Information
After determining what qualifies as a lease, it’s time to start accumulating and reviewing your lease contracts. If there are no contracts available, the lessor may need to be contacted to gather the required information. To set up the leases appropriately under ASC 842, businesses need the following information:
- Lease start and end dates
- Any detail about cancellation or renewal options, including start and end dates for renewals
- All payment amounts and types associated with the lease
- Any details about purchase or transfer options available to the lessee
- If available, the actual or implicit interest rate of the lease
- Any accrued or prepaid expenses associated with the lease
Know Your Options Under ASC 842
There are many options under ASC 842 that help simplify the process of transitioning leases from the old lease standard to the new one and the setup of new leases. It’s a good idea for businesses to be familiar with all available options.
Package of Practical Expedients – If elected, the business does not have to reassess whether any expired or existing contracts are or contain leases. The entity does not have to reassess the lease classification under ASC 840 (capital leases are automatically considered finance leases). Also, the entity would not have to reassess initial direct costs.
Hindsight Practical Expedient – If elected, the entity can use hindsight in determining the lease term. This allows the lessees and lessors to make assumptions regarding the lease term and value of the right-of-use (ROU) asset at commencement by leveraging current information. If elected, this must apply to all leases.
Adjust Comparative Periods – This is a determination of the transition method. The entity can elect to adjust the comparative periods or not. If the entity chooses not to adjust comparative periods, it can make the change as of the effective date of adoption of the standard. This decision must apply to all leases.
Combine Lease and Nonlease Components – If it is too difficult to separate the lease payment into the corresponding lease and nonlease components, this election allows companies to combine them in the determination of the ROU asset and lease liability. This must be applied at the asset class level.
Risk-Free Rate Election – ASC 842 requires the lessee to use the implicit rate in the contract as the discount rate for the lease payments if available. Often this is not available since it’s based on information that the lessor isn’t willing to share. The next option is the lessee’s incremental borrowing rate, which also is not always available or able to be determined. Private companies have a third option allowing them to elect a “risk-free,” e.g., U.S. Treasury, rate for a similar date range to the lease.
Materiality – Overall, an entity is not required to apply U.S. GAAP to immaterial items, so this rule does apply when setting up the leases under ASC 842. FASB considers an item to be material if the omission of the item would change the judgment of any person relying on the report.
Determine if You Need Support
After learning about the time and effort involved in implementing ASC 842, many companies may determine they don’t have the bandwidth to implement the standard alone. The good news is there are many software options and professionals that can help. The Outsourced Accounting Services Team at FORVIS serves clients by working with company management in myriad ways, from helping assess what qualifies as a lease to the final setup of the journal entries, amortization schedules, and financial statement footnotes.
If you have questions about the new lease standard and how it may apply to your business, please reach out to a professional at FORVIS or use the Contact Us form below. You also can learn about our services for small to midsize businesses by checking out our Outsourced Accounting Services webpage.
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