Lease Accounting Standards Effective for Private Businesses in 2022 by Hector E. Aguililla, CPA
After numerous false starts, the time has finally come for private companies to begin reporting leases on their balance sheets and comply with the lease-accounting standards first introduced by the Financial Accounting Standards Board (FASB) in late 2015. While most public companies adopted Accounting Standards Update (ASU) Topic 842 in 2019, privately held business were granted several delays and now have until Dec. 31, 2022, or the first annual report filing of the year, to apply the new lease standards.
Background
Under existing accounting principles, businesses must determine whether to classify leases as capital leases or operating leases based upon the risks and rewards of ownership transferred to them from the arrangement. Capital leases are recognized on balance sheets as both assets and liabilities, for which businesses may claim depreciation and annually deduct interest expense of lease payments. By contrast, businesses treat operating leases on income statements as operating expenses and exclude lease assets and liabilities entirely from their balance sheets. This essentially led to businesses not reporting the true economics of their lease assets and their obligations to pay for those assets, thereby presenting investors and lenders with a skewed representation of their asset and credit risk. As a result, the FASB and the International Accounting Standards Board (IASB) began to look at changing the current model as early as 2006.
Enter the New Lease Accounting Standard
The new standards for lease accounting aim to improve financial reporting transparency and provide lenders, investors and other users of financial statements with a clearer, more accurate picture of an entity’s financial health. Under ASC 842, businesses will for the first time be required to report on their balance sheets the assets and liabilities related to all their leases with terms of more than 12 months. Additional disclosures are required for qualitative and quantitative data about lease transactions, including variable lease payments and options to renew and terminate existing lease arrangements. With the new requirement to record all operating leases, businesses will likely report material changes to various balance sheet and leverage ratios, operating income, after-tax income cash flow, debt and equity. For businesses with large portfolios of lease assets, significantly more debt will be reported on their lease obligations than in prior years, potentially impacting their debt-covenant compliance agreements.
Preparing for the New Leasing Standard
Businesses must first allocate time and resources to track down all their existing lease arrangement and identify their specific rights and obligations relating to each of those assets. Special care must be taken to recognize whether existing service contracts and agreements meet the new definition of a lease and must therefore be reported on balance sheets. Under some circumstances, businesses will uncover the existence of a lease arrangement where they previously assumed one did not exist. These are commonly referred to as embedded leases. Going forward, business will also need to consider how they will monitor and track these lease arrangements in the future, potentially relying on new technology and accounting for those additional costs in budget estimates.
The new leasing standards may also affect how businesses asses their decisions to lease versus buy property or needed equipment. For example, it may be more economically advantageous for one business to buy rather than lease equipment, or the business may seek to modify the terms of an existing lease in order to reduce the impact on its future financial statements.
Early preparation to minimize the impact of the new standards will require businesses to commence the following activities:
- Take inventory of all existing lease arrangements and debt covenants and determine how the business will measure those liabilities on its balance sheet.
- Evaluate new contracts to identify potential embedded leases.
- Determine method for identifying, tracking and monitoring all current and future lease arrangements, including embedded leases.
- Recognize how the new lease accounting standards will affect the business’s balance sheet, credit rating and access to debt.
- Identify opportunities to save costs and minimize impact on the business’s operations and financial position, which may require negotiating lease terms.
- Seek the counsel of experienced accountants and auditors, who can help assess the impact of the new standards and develop a plan to make the transition as simple and economical as possible.
About the Author: Hector E. Aguililla, CPA, is a director of Assurance and Advisory Services with Berkowitz Pollack Brant, where he provides audit, accounting, consulting and litigation support services to a broad range of business clients. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or via email at info@bpbcpa.com.
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