Firms Can Fix What They're Getting Wrong in New Lease Standard

Firms Can Fix What They're Getting Wrong in New Lease Standard

September 07, 2023

With the adoption of Accounting Standards Codification 842,1 operating leases are no longer a footnote disclosure and an off-balance sheet item. The section on leases became effective for private companies and emerging growth companies for fiscal years beginning after December 15, 2021. Now, companies that follow year-end calendar years are seeing the new standard reflected in their financial statements.

All leases create assets and liabilities for lessees: a right-of-use asset representing the right to use an underlying asset for the lease term, and a lease liability representing the obligation to make lease payments.

Leases for assets such as office space and equipment didn’t always need to be shown on a company’s main financial report. Under ASC 842, however, a company will need to report those leases on the balance sheet as something they own temporarily (an ROU asset) and as something they owe money for (a lease liability).

The implementation of ASC 842 has significant implications for companies’ financial statements. By recognizing all leases on the balance sheet, companies’ total assets and liabilities will increase, which may impact their debt-to-equity ratios and other financial ratios. In addition, cashflows shouldn’t be significantly changed from previous generally accepted accounting principles.

Here are the four most common financial statement items where I’ve seen mistakes concerning lease accounting and ASC 842 implementation.

Operating Leases

The treatment of operating lease payments in the cash flow statement is a common area for mistakes. Most companies are used to treating the payments like capital leases under ASC 840 (the previous leasing standard). But under ASC 842, cash payments arising from operating leases are classified within operating activities.

There’s an exception, though. Lease payments for costs to bring another asset to the condition and location necessary for its intended use are capitalized as part of the cost of the asset. These payments should be classified as investing activities.

ASC 842 doesn’t explicitly address the question surrounding the presentation of operating leases. Although a one line method is acceptable, in my opinion, the changes in the ROU asset and lease liabilities arising from operating lease expense should be reported separately, as this most closely aligns with ASC 230.2

As such, the amortization of the operating ROU asset would be presented as a non-cash adjustment from net income/loss and the change in the operating lease liability due to cash payments as a change in operating assets and liabilities.

Prepaid Rent for Finance Leases

Companies are inappropriately including prepaid rent for finance leases in financing activities with the payments for the principal portion of the finance lease liability. Payments for prepaid rent for a finance lease are investing activities and not financing activities. This includes when a lessee pays for a lessor asset for finance leases.

However, if the lease classification is uncertain at the time of prepayment, it’s acceptable to present the prepayment based on the expected lease classification at commencement — for instance, if the lease is expected to be an operating lease to include the prepayment in the operating section of the statement of cash flows.

Non-Cash Supplemental Disclosures

While most companies know to include information on lease liabilities arising from obtaining an ROU asset, companies are inappropriately excluding other non-cash events such as changes related to modifications or reassessments — even when there’s a decrease in the ROU asset.

Each of the above should be included in non-cash supplemental disclosures. However, companies could present all items in one non-cash line item instead of separately.

Short-Term Leases

Under ASC 842, a company can use a practical expedient that allows, by class of underlying asset, for leases with terms under 12 months to avoid capitalization (that is, no ROU asset). Instead, companies can recognize the lease payments in profit and loss on a straight-line basis over the lease term, like accounting for operating leases under ASC 840.

Companies often don’t realize the 12-month rule is a bright-line rule. As such, leases with a 12-month and one day term wouldn’t fall under the practical expedient.

At commencement date, if a 12-month lease has a renewal option, the company must consider if it’s reasonably certain that the option would be exercised. Companies are inappropriately not considering the renewal options.

ASC 842 has very specific guidance regarding when a lease loses its short-term lease exemption. When the company extends the lease for more than 12 months past the previously determined lease term, the lease would then be required to have an on-balance sheet recognition, regardless of the determination made at the lease commencement. This is causing companies to inappropriately include short-term costs in financial statement disclosures instead of on the balance sheet and with the disclosure’s appropriate category.

For example, consider a lease that was classified as short-term (under 12 months) at commencement. But six months into the lease, the lease is modified to extend the termination date for another 18 months. The lease would no longer qualify for the short-term exemption, as the modification extends the lease term more than 12 months from the end of the previously determined lease term. The company would need to record an ROU asset six months into the original lease term and not wait until the extension begins.

The first round of ASC 842 implementation revealed areas where companies commonly misapplied the standard due to unfamiliarity. For proper reporting, third parties can provide value by ensuring that companies remain in compliance with all relevant accounting standards and are equipped for ongoing success.

This article was originally published in Bloomberg Tax.

  1. ASU 2021-05
  2. ASU 2016-15