Lease accounting rules are soon to change for private companies that have not yet adopted the provisions of ASC 842, Leases. As privately held entities prepare for implementation, many may wonder, “what are the practical implications of the new rules?”
Impacts of the new lease accounting standard run the gamut: affecting amounts reported in financial statements, changing the way key financial ratios and measures are assessed, and requiring countless accounting and administrative preparations. Below, we highlight these key changes.
Impact on amounts reported in financial statements
Under ASC 842, virtually all leases will be reflected on the balance sheet. This especially marks a big change in financial statement presentation for lessees with operating leases, as they are not recorded on the balance sheet under legacy GAAP. Lessees will report new asset and liability line items titled right-of-use (ROU) assets and lease liabilities. This means that entities will generally report larger assets and liabilities than in the past. Entities with more significant lease portfolios are impacted by the new standards to a greater extent than those that are not as involved in lease arrangements. Note that lease accounting changes in the income statement are generally not considered significant.
Impact on financial ratios & measures
Since entities will report new assets and liabilities on their balance sheets, certain financial ratios and measures are impacted. This affects strategic assessments and valuation estimates made by stakeholders, including lenders, banks, potential investors and owners. Financial statement users must recalibrate the way they assess certain metrics, including how they are assessed as part of bank covenants, borrowing base calculations and asset impairment analyses, to name a few. Metrics influenced by higher assets and liabilities include many commonly referenced ones, such as the following:
- Debt to equity ratio
- Debt to total assets ratio
- Debt to capital
- Assets to equity
- Cash return on assets ratio
- Debt coverage ratio
As the transition provisions of ASC 842 do not require restatement of financial statements for prior periods upon adoption, certain ratios and metrics may not be comparable for all periods assessed. This makes period-over-period analytical comparisons more difficult to evaluate.
Impact on accounting & administrative preparations
Finance professionals leading their organization’s upcoming adoption of the new standard have a number of undertakings to ensure a smooth transition. Tactical preparations include:
- Assessing contracts and identifying arrangements for which ASC 842 is applicable,
- Evaluating classifications of leases,
- Deciding inputs (i.e., discount rates),
- Determining lease consideration, identifying lease and nonlease components and allocating consideration to components,
- Considering whether to elect available practical expedients,
- Determining how to compute financial statement amounts and maintain data to support journal entries (i.e., using in-house spreadsheets or a professional lease accounting tool),
- Adding line items to the chart of accounts for ROU assets and lease liabilities, and
- Establishing methods to monitor required reassessments and remeasurements.
There are numerous details involved in accomplishing the tasks at hand for implementation of the new accounting standard, each of which may have its own set of practical implications. As an example of a specific implication of one decision, in selecting a discount rate for use in computing the ROU asset and lease liability for a lease, a higher discount rate will result in lower asset and liability amounts, and vice versa. Another choice to carefully consider is whether to apply certain practical expedients, which in some cases, may ease the administrative burden of applying the new lease rules, but will result in higher ROU asset and lease liability amounts recorded on the balance sheet. Judgment is involved in many of these decisions.
In light of the many assessments that need to be made and processes that should be put in place, it is highly advantageous to focus efforts long before the implementation date and to designate responsibility for overseeing ASC 842 implementation and continuation efforts.
An early step to take in preparing for the adoption of the new lease accounting rules is to contemplate how they will impact your organization, in terms of new financial statement presentation, changes to financial ratios and metrics as well as the need for administration and oversight. Contact our team to learn more about how Sikich can help you assess these concepts and prepare to implement the new lease accounting model.