Implementation FAQs on ASC 842 for private entities under U.S. GAAP

By Louis P. Le Guyader, CPA

Private reporting entities will release financial statements in 2022 that will report all leases “on balance sheet” for the first time. The FAQs provided in this document spotlight the aspects of ASC 842 that are most relevant for “private entities.” 

Background

In years prior, leases that were described as “operating Leases” were held “off balance sheet” and disclosed in the financial statement notes. Operating leases are by far the most frequently reported type of lease contract and so the new accounting treatment represents a significant balance sheet shock for most companies. 

All “public entities” have implemented 842 by now. Private entities were granted two postponements. In November 2021, the Federal Accounting Standards Board (FASB) declined to grant a third postponement. The document contains guidance direct from 842 as well as takeaways from the experiences of public entities.

In 2016, FASB issued ASU 2016-02 to announce the new U.S. Generally Accepted Accounting Principles (GAAP) leasing standard ASC Topic 842. The principal purpose of this leasing standard is to require that all lease contracts are recognized on balance sheet. The standard contains an exception for short-term leases, those under 12 months in term, which can remain off balance sheet. The standard also provides different income statement rules for “finance leases” (previously known as “capital leases”) and operating leases. 

There are many other secondary aspects of this standard. Legacy U.S. GAAP was known as FAS13, the name of the original U.S. GAAP standard on leasing. FAS13 had been mapped into ASC Topic 840 when the Accounting Standards Codification was launched in 2009. 

FAQs 

1.    Scope — Which reporting entities are subject to 842? 

All U.S. GAAP reporting entities are now subject to 842. For most private entities, 842 was postponed until the start of “interim periods beginning after December 15th, 2020.” This means that fiscal year ends starting Dec. 16, 2021, must incorporate 842. 

“Private entities” includes both for-profit and nonprofit entities. This group will generally include entities that do NOT file with the U.S. Securities and Exchange Commission but are required to prepare audited financial statements under U.S. GAAP. “For profit” private entities are included as are “not-for-profit entities.” 
 
2.    Private entities must now report leases on balance sheet. Which private entities may have been subject to these new reporting rules before 2022?

If the entity is “private for-profit” or “not-for-profit” but issued publicly traded debt, then they should have followed the lease rules of “public entities.” They should have been reporting all leases on balance sheet for several years before now. 

3.    Scope — Which leases are subject to 842? 

All lease contracts as defined by U.S. GAAP

4.    Scope — Has the U.S. GAAP definition of “leases” changed?

The definition of leases has been broadened. And the interpretation of what that definition is meant to capture has expanded. Private entities will need to interpret 842 as it was meant to be written — from the economic and not the legal perspective. 

“Leases” are now more broadly understood to include any agreements that transfer the right to control an asset to a lessee. More contracts may be subject to 842 than were subject to 840. The dollar amount of lease payments recognized “on balance sheet” may increase substantially under 842 as compared with the dollar amount of lease payments disclosed under 840. 
 
5.    What are other factors that may cause the amount of reported lease contracts to jump under 842?

Since 840 contracts only required disclosure, the controls around lease contracts may not have been as stringent as will be required under 842. Since contracts were disclosed but not recognized there was little incentive to centralized control over contracts such as car rental agreements, contracts for office furniture and equipment such as copiers, etc. In some circles the impression that 840 leases were “underreported” will translate into a jump in reported lease contracts under 842 over and above the change in the “lease” definition. 

6.    Categorization — In the year of adoption, are “capital” leases mapped into “finance” leases and do “operating” leases remain categorized as “operating” leases?

Yes, if the reporting entity elects a “practical expedient” approved by the FASB as an amendment to 842. By keeping the same categorization, the reporting entity avoids the difficult transition from the 840 criteria to the 842 qualifications tests. The tests will be applied to all lease agreements after the first day that 842 is adopted. 

Otherwise, the existing contracts are re-examined using the qualifications tests even though they were categorized using the criteria. Public entities have reported the need to present certain capital leases as operating leases and some operating leases as finance leases. 

7.    Previously under 840, leases considered operating leases were kept off balance sheet. 842 requires all leases to be recognized on balance sheet. Are there any leases that may remain off balance sheet under 842?

Yes. The following lease contracts are not recognized on balance sheet under 842:

1. Short-term leases with contractual maturities of 12 months or less from the reporting date (this exemption requires an election).
2. "Build to Suit” lease accounting is largely eliminated. These arrangements must generally be reclassified as finance or operating leases under 842 or fall under another U.S. GAAP rule. 
3. Lease contracts that have been signed but have not started are generally kept off balance sheet until their inception date. Most public companies reported the dollar value of those contracts in disclosures. Private entities will need to have contract terms carefully reviewed to determine their inception date. The inception date triggers the requirement of on balance sheet recognition.

8.    Does 842 maintain the 840 categories of capital and operating leases?

No. 

Under 840, leases were classified as either capital leases or operating leases on the basis of four criterion matched to the contracts. Capital leases were recognized on balance sheet. Operating leases were kept off balance sheet and a schedule for their future lease payments was disclosed. 

Under 842, leases are classified as either finance leases or operating leases on the basis of a five-part qualifications test. Both are now recognized on balance sheet and the future lease payments for both are to be disclosed. 

In very general terms, a capital lease is a finance lease and the accounting is similar. Also in very general terms, the income statement accounting for operating leases remains unchanged. However, under 842 these operating leases must be recognized on balance sheet and the balance sheet accounting for 842 finance and operating leases is quite different. Be aware that the “devil is in the details” regarding the similarities pointed out.

9.    Balance sheet: Finance leases — What has been the practice thus far in presenting finance leases on balance sheet?

Finance lease accounting is similar to capital lease accounting. On the asset side of the balance sheet, the right-of-use asset is more clearly labeled as such but often remains as a line item in property plant and equipment. It is then subjected to amortization although the terms and accounts depreciation expense and accumulated depreciation remain widely used. 

The finance lease liability is often presented as a line item in the debt portion of liabilities. 

There are exceptions to both treatments wherein the finance lease assets and liabilities are presented as new separate line items on the balance sheet. This appears to more a matter of taste than rule.

10.    Balance sheet: Operating leases — What has been the practice thus far in presenting operating leases on balance sheet?

The major change imposed by 842 is that operating leases must now be recognized on balance sheet. (See “materiality” below). In almost all cases, the lessee follows established U.S. GAAP practice in separating the operating lease liabilities into two groups: a current operating lease liability and a non-current lease liability. There are two modalities then applied: 

1. Where the operating lease recognition represents a material balance sheet change, a A.    separate line item in current liabilities is recognized for the current operating lease liability. A separate line item in non-current liabilities is recognized for the non-current operating lease liability. 
2. Where the operating lease recognition does not represent a material balance sheet change, the current and the non-current items are included in a larger subcategory of current and non-current liabilities. 

11.    Income statement: Finance leases — What is the basic presentation of finance leases in the income statement?

An amortization or depreciation expense for the right of use asset is charged to earnings and incorporated in a suitable line item before earnings before Interest and taxes (EBIT). Normally this charge is estimated on a straight line basis across the term of the lease agreement. 

An interest expense is recorded for the lease liability using the relevant discount rate (see “discount rates” below). The liability is amortized using this discount rate using the effective interest method. The interest expense is normally a component of interest expense, after EBIT. 

12.    Income statement: Operating leases 

Under both 840 and 842, a single lease expense is reported and is normally the same as the annual lease payments. This lease expense is charged to a suitable account before EBIT. The interest accrued on the lease liability and the amortization of the right of use asset are not reported in separate line items in the income statement. 

13.    Materiality: When has adoption of 842 been considered material?

In general, the on balance sheet recognition of operating leases has been the principal candidate for 842 representing a MATERIAL change. However, if the number and amount of operating leases is insignificant, then the adoption of 842 may not be material. 

• In general, the income statement impact of 842 has NOT been considered MATERIAL. 
• In general, the statement of cash flow impact of 842 has NOT been considered MATERIAL.
• In general, even where a cumulative effect on adoption of a new accounting standard has necessitated an entry to the opening balance of RETAINED EARNINGS, the statement of equity impact of 842 has NOT been considered MATERIAL. 

14.    Disclosures: Does 842 require different disclosures in comparison to 842?

Yes, the 842 disclosures are far more extensive than under 840. 

Often this necessitates a new note in the audited notes to the financial statements. 

In 840, the lease disclosures were a component of the note on commitments and contingencies. They were composed principally of the future expected lease payment schedule on operating leases, the kind of leases that remained off balance sheet under legacy U.S. GAAP. See Exhibit 1 for a partial list of the most frequently read disclosures. 

15.    Are there any shortcuts that private entities can use in the year of adoption for 842?

Yes. 

Under the right circumstances, the “risk-free rate” can be used as the discount rate as described above. This will save the time and expense of a pricing exercise. 

The FASB also granted a series of practical expedients in the year of adoption. The most frequently used and disclosed was the permission to map capital leases into finance leases, and presumably all other leases already classified as operating leases into the new operating lease category. The application of the qualifications test to determine the classification was waived for such grandfathered contracts. This saves enormous amounts of time and expense. 

Outside expert services and software can now be obtained so as to avoid building extra staff and accounting systems from scratch. When the software has already been vetted by a public entity and the outside experts have experienced several lease adoptions, it can also increase the accuracy of a private entity’s year-of-adoption accounting. 

16.    The new lease accounting requires that all leases are reported on balance sheet and that the lease liability represents the present value of all future expected lease payments pursuant to the lease agreement or contract. What discount rate must be used in order to estimate this lease present value?

There are three rates that may qualify for use as the discount rate in 842 lease accounting: the implied rate, the incremental borrowing rate of the lessee, and the risk-free rate. 

The implied rate is understand to be the rate of return that the lessor has used to estimate the annual lease payments. As described by most public entities, this rate is rarely if ever available. 

The incremental borrowing rate is the cost of debt the lessee would incur for a borrowing similar to the lease liability. It must reflect the same maturity as the lease contract, represent a collateralized borrowing where the leased item is the collateral and the collateral agreement is represented by the lease agreement. This rate must also represent the location and circumstances for the leasing arrangement; for example, this rate depends on the currency in which the contract is agreed. The incremental rate must be estimated when the implied rate is not available and the lessee otherwise has credit relationships that result in observable costs of debt. 

The risk-free rate may be used only if both the implied rate is not readily available, and the incremental borrowing rate is not readily determinable. Among other things this rate can be selected if the private entity is not a borrower (its cost of debt is not observable) or if the term or conditions of the lease agreement are dramatically different than its normal borrowing status (for example, a private entity with a three-year borrowing horizon in the maximum might claim that its incremental borrowing rate is not determinable for a longer-term lease maturity, say 10 years). Since a tradeoff and judgment is required, many see the use of the risk-free rate as an election made by private entities only. 

In practice, the risk-free rate in the United States is the rate on the treasury yield curve that represents the maturity of the lease contract. 

17.    Are there tradeoffs in the selection of the risk-free rate? 

Yes, the higher the rate the lower the initial lease liability and the higher the annual interest expense. 

The opposite is also true: the lower the rate, the higher the initial lease liability and the lower the annual lease expense. Is there any disadvantage to using “risk-free rates” to discount lease payments?

Of all the rate alternatives under 842, the risk-free rate is likely to be a rate that is lower than both the lessor’s implied rate and the lessee’s incremental borrowing rate. As a result, the lease obligation that will be recorded will be higher at the inception of the lease. Interest accruals whether reported separately as in finance leases or used only to amortize the lease obligation under operating leases will be lower.