Private companies must adopt the new lease accounting standard starting in 2022. Early adopters caution that the rules can bulk up balance sheet liabilities, which could trigger debt covenant violations. This article includes important information that companies should be aware of as they update their processes and systems to reflect the changes.
No More Deferrals
Accounting Standards Update (“ASU”) 2016-02, Leases (Topic 842), is effective for most private companies for fiscal years beginning after December 15, 2021, and interim periods within the fiscal year beginning after December 15, 2022. Early adoption is permitted.
The updated guidance requires companies to report the full magnitude of their long-term lease obligations on their balance sheets. This is a major change from existing practice. However, while the new guidance triggers a change in classification, nothing has changed economically with leases.
The new rules took effect in 2019 for public companies, but they were deferred twice for private companies. In November 2021, the Financial Accounting Standards Board (“FASB”) voted against deferring the changes beyond 2022. Therefore, all private companies must adopt the changes this year.
5 Critical Issues
Based on surveys from lease accounting software vendors, most private companies have not yet adopted the rules. The vendors flagged the following as the top five issues to pay attention to when implementing the lease rules:
1. Developing a process to create an inventory of leases. Companies must assemble a cross-departmental team with members from the real estate, procurement, legal and information technology departments to identify all leases. While most companies have a good handle on real estate leases, information about other types of leases (for instance, vehicle and equipment leases) tends to be decentralized and not always readily available.
2. Selecting appropriate accounting policies when implementing the changes. The lease standard has subtle nuances that must be ironed out in the period the company implements the changes. For example, the guidance includes three practical expedients that have to be selected as a package when adopting the new rules. Private companies also may need help selecting a discount rate — whether using an incremental borrowing rate or a risk-free rate. The FASB recently provided accommodations for private companies that allow them to select a risk-free rate by asset class.
3. Developing in-house expertise. A major part of adopting the new lease rules is extracting data, such as a lease commencement date, lease payments, term options and the discount rate. Many public companies that already adopted the changes had internal staff who sufficiently understood the updated guidance and could manage the implementation process. Private companies without personnel who are versed on the changes would likely need to hire a consultant to join their team or work with their CPAs.
4. Finding the right software solution. Software should handle the initial adoption of the new lease rules, as well as the “go-forward” entries on a monthly basis and required disclosures. If an agreement is modified, the software should be able to process the accounting for you. It should function into a company’s new control environment.
5. Keeping the lease inventory current. Leases are dynamic, so you can’t just “set it and forget it.” After the implementation date, new leases may be signed; old ones may expire or be retired. These items may need to be added to (or removed from) the balance sheet. Some agreements may be amended, requiring subsequent measurement. The current details of lease agreements must continuously be tracked to provide transparent disclosures under the updated guidance.
We Can Help
We can help you understand how the changes will impact your company’s financial statements and loan covenants. Contact us for more information.