New Lease Accounting Standard Nearing Implementation Date

In February 2016, the FASB issued Accounting Standards Update (ASU) 2016-02, Leases (Topic 842) to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The new lease standard is nearing implementation date.

Following the issuance of ASU 2016-02, the FASB issued several additional ASUs addressing various issues related to Topic 842, Leases.  Collectively, these standards were initially effective for private and NFP entities with fiscal years beginning after December 15, 2019; however, the effective date was twice delayed and is now effective for fiscal years beginning after December 15, 2021.

With 2022 right around the corner, the team at Anderson ZurMuehlen wants to help you and your organization prepare for the significant changes required under the new lease guidance.  Below we have included a summary of the changes, an example of a basic operating lease under Topic 842, and suggestions for your organization as you begin to prepare for implementation.

Summary of Topic 842, Leases

As outlined by the FASB, “The core principle of Topic 842 is that a lessee should recognize the assets and liabilities that arise from leases.”  When comparing Topic 842 with the previous lease guidance, the main difference is the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases under previous guidance.  Under previous guidance, operating leases were NOT carried on the balance sheet. 

Operating Lease vs. Finance Lease

Under the new lease guidance, there are five criteria when determining whether a lease is an operating lease vs. a finance lease.  If any of the below criteria are met, the lease will be classified as a finance lease. If none of the below criteria are met, the lease will be classified as an operating lease. 

  1. Transfer of ownership – Will ownership transfer to Lessee at the end of lease term?
  2. Bargain purchase option – Is Lessee reasonably certain to exercise a purchase option?
  3. Alternative use – Will the leased asset have no alternative use to the lessor at the end of the lease?
  4. Major part of lease term – Is the lease term a major part of the economic life of the underlying asset?
  5. Present value of lease payments – Does the present value of lease payments equal (or exceed) substantially all of the fair value of the leased asset?

Under the new guidance, for an operating lease, a lessee is required to do the following:

  • Recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments on the balance sheet.
  • Recognize a single lease cost, calculated so that the cost of the lease is allocated over the lease term on a generally straight-line basis. 
  • Classify all cash payments within operating activities in the statement of cash flows.   

For finance leases, a lessee is required to do the following:

  • Recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments on the balance sheet.
  • Recognize interest on the lease liability separately from amortization of the right-of-use asset.
  • Classify repayments of the principal portion of the lease liability within financing activities and payments of interest on the lease liability and variable lease payments within operating activities in the statement of cash flows.
Topic 842, Leases Nearing Implementation Date

Scope Exceptions

There are also a number of scope exceptions.  The new lease standard does not apply to:

  • Leases of intangible assets
    • Leases of biological assets
    • Leases of inventory
    • Leases of assets under construction
    • Leases of exploration or use of certain natural resources

Additionally, a lessee can make an accounting policy election not to recognize lease assets and lease liabilities for leases with a term of 12 months or less.  If this election is made, the entity should recognize lease expense for short-term leases on a straight-line basis over the lease term.

Transition

When making the transition from the old guidance to the new guidance the FASB has allowed a modified retrospective approach to ease the burden of the transition.  Under the modified retrospective approach, existing leases as of the effective date continue to be assessed under current lease accounting standards unless the lease is modified. If the lease is currently an operating lease, the entity is required to record a lease liability and right of use asset in the period of adoption with an adjustment to beginning retained earnings if necessary. If comparative financial statements are issued, prior year balances are not restated and financial statement disclosures should include disclosures from both the new and old guidance during the transition.

Banking Considerations

It is important to note that the changes under the new guidance are likely to impact debt covenants.  Your organization should begin calculating the impact and discussing the potential implications with your banking relationships as soon as possible. 

Basic Operating Lease Example – Topic 842

Below is an example of a simple operating lease with related journal entries and amortization tables under the guidance of Topic 842. 

Basic Information 

  • Base rent per year = $10,000
  • Applicable interest rate / discount rate = 5%
  • Number of periods = 10 years   
  • Payment timing = Beginning of the period 

Sample Journal Entries – Period #1 

  • Right-of-Use Asset              $77,217 [dr] – {a} see table below 
  • Lease liability                       $77,217 [cr] – {a} see table below

To record right-of-use asset and lease liability at lease commencement date. 

  • Lease liability              $10,000 [dr] – {b1} see table below 
  • Cash                             $10,000 [cr] 

To record annual lease payment to the lessor. 

  • Lease expense              $10,000 [dr]
  • Right-of-Use Asset       $6,139 [cr] – {c1} see table below 
  • Lease liability                $3,861 [cr] – {c2} see table below 

To record annual the annual lease expense and amortization of the right-of-use asset. 

Sample Journal Entries – Period #2

  • Lease liability               $10,000 [dr] – {b2} see table below 
  • Cash                              $10,000 [cr]

To record annual lease payment to the lessor. 

  • Lease expense.                       $10,000 [dr]
  • Right-of-Use Asset.                 $6,446 [cr] – {d1} see table below 
  • Lease liability                           $3,554 [cr] – {d2} see table below 

To record annual the annual lease expense and amortization of the right-of-use asset. 

Topic 842, Leases Nearing Implementation Date

Next Steps

Our team understands implementing the new lease standard can be complicated and time-consuming.  As we quickly approach 2022, we encourage your organization to being the process of implementation by taking the below steps.  

  • Take inventory of all leases
  • Gather key data about each lease
  • Understand and review options for certain lease policy elections
  • Identify leases as operating or finance leases
  • Apply the new standard using excel or lease accounting software
  • Generate lease journal entries
  • Produce updated balance sheet and income statement

The Anderson ZurMuehlen Team is proud to be a resource to you.  Our team has a number of resources to help you get prepared for implementation.  From assistance with amortization tables to help to developing a lease accounting policy, our team is here for you. If you have questions regarding the new lease standard, please contact us.

This article was written by Grace McKoy, CPA, CVA, and Shareholder in our Missoula office.

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