Lease Rules Affecting Construction
If you have delayed starting your implementation of Accounting Standards Codification (ASC) 842, Leases, it is now time to get serious about adopting this new standard. After cries for new standard implementation relief, delays were approved by FASB; however, those deferments have ended, and it is time to implement the new standard. For nonpublic companies and certain nonprofit entities, this new standard is effective for annual periods beginning after December 15, 2021, and interim periods beginning after December 15, 2022.
As a reminder, this new guidance requires lessees to recognize substantially all leases on their balance sheets as lease liabilities with a corresponding right-of-use (ROU) asset. FASB updated the definition of a lease; therefore, some contracts that are not currently accounted for as leases may be considered leases under ASC 842. Under the new definition, a lease is present when a contract, or part of a contract, conveys the right to control the use of an identified asset for a period of time in exchange for consideration. For a lease to be in place, a customer must have both the power to direct the asset’s use and the ability to obtain benefits from its use.
An identified asset must be either explicitly or implicitly identifiable and physically distinct. There may be situations where even if there is a specified asset, the contract may not be accounted for as a lease. This occurs when the supplier has the substantive right and practical ability to substitute alternative assets throughout the use period, which would provide them with economic benefit in choosing to substitute the alternative asset. This assessment will require management judgment.
There is some good news to the standard related to an exception for short-term leases. This exception allows a lessee to not record a lease when the term is 12 months or less, unless the lease contains a purchase or renewal option that will likely be executed. Short-term leases qualifying for the exception will continue to be accounted for as operating leases under the previous lease guidance, ASC 840, whereby payments are recognized on a straight-line basis over the lease term.
FASB has allowed for some transition relief, and if elected, an entity does not need to reassess expired or existing contracts for leases, the initial lease classification, or initial direct costs. Keep in mind that errors in initial lease classification between capital and operating under ASC 840 would need to be treated as an error correction as opposed to a transition adjustment.
Changes to financial statements and related disclosures will be significant with the adoption of ASC 842. Here are just a few examples of how this standard will affect lessee financial statements and are not all encompassing:
- A cumulative effect adjustment to the opening balance of retained earnings, as of January 1, 2022, for entities that report on a calendar-year basis and elect a modified retrospective adoption. The standard also allows for a full retrospective adoption with the cumulative effect adjustment to beginning retained earnings for the earliest period presented.
- Lease liabilities represent the present value of unpaid lease payments and are typically broken out between operating and finance leases on the balance sheet with an option to disclose separately in the notes.
- Operating ROU assets are initially recorded as the lease liability plus prepaid rents and initial direct costs, less lease incentive and impairment.
- Finance ROU assets can be shown separately on the balance sheet or included within property and equipment, with the amounts disclosed in the notes.
- Footnote disclosures under ASC 842 are more extensive and require both qualitative information in addition to quantitative disclosures.
This high-level summary is designed to give you a very broad overview of ASC 842. Adoption of this new standard will be complex, both for lessors and lessees, as there are many other implementation considerations that will need to be assessed. For more information, reach out to a BKD Trusted Advisor™ for help today or submit the Contact Us form below.