Adopting the new lease accounting standard has proven to be no easy task. Private companies are running out of time to implement this new accounting standard. Companies must report their leases based on this new standard in their December 31, 2022, financial statements. Waiting until year-end and trying to address the lease standard implementation while closing out the year and preparing for a year-end audit will be highly stressful. With that in mind, there are several actions your company can take to ensure a smooth adoption before year-end.
Six Steps to Ensure Successful Adoption of the New Lease Accounting Standard
1. Address the Critical Elections, Assumptions and Estimates
The standard requires management to make assumptions, develop estimates, use professional judgment and decide on the transition method and practical expedients.
Recommendation – Involve your accountants on the front end to help you address the critical assumptions, elections and estimates. This collaboration will result in a more efficient process and minimize the risk of material adjustments during year-end audit fieldwork.
2. Engage Your Lenders
The addition of current and long-term lease liabilities on your balance sheet may adversely affect your financial covenants.
Recommendation – Review your covenant calculations, identify those that will be impacted and communicate with your lender to determine whether any changes to your borrowing arrangements are necessary before year-end.
3. Locate Your Existing Lease Agreements
Unfortunately, this is proving to be more time-consuming than expected. Although you may have previously located lease agreements when completing the footnote disclosure for the prior year’s financial statements, there could be missing amendments, renewals, etc. Depending on the size and structure of your organization, lease agreements may not be organized or stored in a central location, could be maintained by multiple departments or stored on drives that are not accessible.
Recommendation – Review your existing lease population, identify the missing documentation and start tracking it down. Do not assume that you have everything you need or that the missing documentation is at your fingertips.
4. Review Month-to-Month Leases
Under the new standard, these leases require special attention and judgment to arrive at the lease term. Although the stated term is less than one year, these leases can be considered either short-term and expensed on a straight-line basis or long-term and capitalized on the balance sheet as a Right of Use (“ROU”) asset and lease liability.
Recommendation – Don’t assume you can treat month-to-month or evergreen leases the same as under the previous standard (expensed on a straight-line basis). Determining the appropriate lease term, which will drive the accounting treatment, will require an analysis of the nature of the agreement, how long it has existed, and management’s expectations for the future.
5. Review Related-Party Leases
The standard requires you to account for these leases based on “legally enforceable rights and obligations.” Enforcing the rights and obligations in a contract is a matter of law. If the lessee and the lessor both have the right to terminate the lease without the other party’s permission and face only an insignificant penalty for doing so, the lease would not be considered enforceable.
Recommendation – Because practices and processes for establishing contracts vary across entities and jurisdictions, a business should consider its established practices and processes when determining whether its agreements create enforceable rights and obligations. Also, don’t assume that because there is no written agreement, the lease is outside the scope of the new standard. Determining whether an arrangement creates enforceable rights and obligations requires careful analysis and potentially a consultation with legal counsel.
6. Review for Embedded Leases
The definition of a lease has changed under the standard, and there may be leases embedded in transportation, warehousing, service or information technology agreements.
Recommendation – Review your general ledger accounts, identify recurring payments and determine if there are related contracts that warrant further review.
There is no time like the present to proceed with the adoption process. If you have any questions or need assistance with implementing and maintaining compliance with ASC 842, Moore Colson can help. Contact us for more information.