In Retrospect – A Look Back at Adoption of the New Accounting Standard for Leasing
Private companies were required to adopt the new lease accounting standard, FASB ASC 842, for their calendar year-end reporting date as of December 31, 2022. The standard requires that all leases with terms longer than 12 months be recorded on companies’ balance sheets by calculating the present value of lease payments over the lease term. In addition, companies must recognize a long-term right-of-use asset and lease liabilities, current and long-term portions. This was a significant change from prior accounting standards, where historically, the more prevalent leases classified as operating leases were generally expensed as lease payments were made and were not accounted for on the balance sheet.
The initial written standard update in 2016 was hundreds of pages long, followed by the release of numerous updates, changes and accounting guides. As a result, there was much to digest and consider when looking at a company’s leasing activity and what it would take to adopt the new standard. Now that the initial implementation is behind us, we wanted to take a few minutes to reflect on some of the insights gained from assisting companies with their accounting and reporting for this major change in lease accounting.
1. Implementation adjustments were primarily a balance sheet “gross up” at the beginning of the year of adoption.
Most private companies elected to adopt the new leasing standard on the first day of the year of adoption (the “effective date” method), which was January 1, 2022, for companies with a calendar year reporting period. Alternatively, companies presenting comparative financial statements could elect to apply ASC 842 retrospectively as of the beginning of the first year presented in its financial statements (January 1, 2021, for calendar year reporting) and restate its prior year’s financial statements. However, we discovered that this method of going back effectively two years to be more challenging and time-consuming.
ASC 842 requires that the initial accounting to record operating leases on the balance sheet be accounted for using future payments from the effective date forward rather than going back to day one of each lease and trying to determine what the asset and liability balances would be on the effective date. As a result, the initial adjustment to bring operating leases onto the balance sheet on the effective date was almost always a balance sheet adjustment recognizing a new long-term right-of-use operating lease asset and operating lease liabilities, both current and long-term portions. In most cases, the implementation adjustment for private companies had no initial impact on equity accounts.
2. Computer programs were helpful, but users could not “set it and forget it.”
Many companies used software programs to assist with the new lease accounting. We found that while using software programs to help calculate lease assets and liability balances saved time, it was critical to analyze the output reports carefully to ensure the accuracy of the reporting. The adage “garbage in, garbage out” continually went through my mind while reviewing outputs from computer software tools. It is imperative that the lease data input, including lease payment amounts and dates, be 100% correct. Otherwise, the resulting lease asset and liability balance calculations, journal entry reports and financial statement disclosure data output would not be accurate. Often, we found users of the software would make the mistake of assuming the software output data was correct simply because the computer program calculated it and not take a step back to ask themselves, “Does this information make sense?” The generated reports still required a human eye to review the data and ensure accurate reporting.
3. Adjustments to recognize straight-line lease expense were generally not material.
Once the initial accounting was complete on the effective date, companies had to account for operating lease expense straight-line over the life of the lease. When a lease has escalating lease payments over the lease term, or there are months with no lease payments required, the periodic lease payment will not equal the straight-line lease expense. While this has always been the requirement for operating leases, the more detailed approach often resulted in calculations that automatically worked in straight-line lease adjustments. We found that in most cases, these adjustments were not material to a company’s financial statements, leaving company management with the option to either adjust the periodic expense, or not. If not, the result of the new lease accounting standard was the recognition of equivalent right-of-use operating lease assets and liabilities in a company’s year-end balance sheet, with no change to equity accounts, no change to the statement of income and no change to the statement of cash flows.
4. Related party leases presented some challenges.
For many private companies we worked with on lease accounting, there were scenarios where an operating company leased a facility from a sister company under common ownership. In certain instances, the entity that owned and leased the real estate to the operating company was sometimes consolidated in the financial statements, and sometimes it was not. These related party leases were occasionally formally executed, while at other times, they were informal and unwritten. When the lease terms were informal and unwritten, careful consideration had to be given to applicability under the new leasing standard.
Throughout the implementation, specific questions needed to be answered, which weren’t always easy to conclude. For example, is the lease considered month-to-month, thereby making it not applicable to capitalize the balance sheet? Or does the total lease term need to be estimated for purposes of calculating a capitalizable lease asset and corresponding liability? If the lease term is considered month-to-month, but there are leasehold improvements included in the balance sheet with several years of depreciation remaining, do those need to be now written off? If the leasing and operating entities are consolidated for financial reporting purposes, does the lease still need to be capitalized to the balance sheet and eliminated? These are just a few questions among many!
Thankfully, the Financial Accounting Standards Board (FASB) and American Institute of Certified Public Accountants (AICPA) provided guidance to address these issues; the latest of these was issued in March of 2023 when, inopportunely, many private companies had already closed the books and issued financial statements for 2022.
5. Leasing activity varied greatly between companies.
No two entities are alike, whether they are in the same industry or not. We saw some construction companies with a great deal of leasing activity adding millions of dollars of operating lease assets and liabilities to the balance sheet. In contrast, others had no changes to the balance sheet. We saw companies with millions of dollars of short-term month-to-month leases but no long-term leases. We saw companies with related party leases and some without. Each company’s leasing activity had to be scrutinized on a lease-by-lease basis. Financial statement disclosures varied considerably across the board and had to be custom tailored to the company’s specific scenario.
A few years ago, companies were required to implement FASB ASC 606 for revenue recognition. It was expected to significantly impact construction companies’ financial reporting. However, when all was said and done, we found very few cases where accounting adjustments were necessary, and there were several pages of new “boilerplate” descriptive disclosures added to construction company financial statements.
The impact of ASC 842 was much more widespread and impacted almost every company. There were large adjustments to balance sheets, more detailed and customized financial statement disclosures needed, and an all-around greater effort required from internal accounting staff and external accountants, like Dannible & McKee, to ensure that companies implemented the new complex standard appropriately.
With initial implementation behind us, it is now equally important to continue to monitor leasing activity moving forward. ASC 842 for leases will need to be accounted for on an ongoing basis. It is much easier to put procedures in place to identify, classify and account for leases throughout the year versus trying to gather all the data and go through lease accounting adjustments all at once for year-end closing and financial reporting.
If you have any questions regarding your lease accounting, please don’t hesitate to contact us. The experts at Dannible & McKee are always available to offer assistance.
Contributing author: Benjamin A. Sumner, CPA, is an audit partner with over 13 years of experience providing auditing, accounting and advisory services to a wide variety of privately-held businesses. For more information on this topic, contact Ben at email@example.com or (315) 472-9127.