Accounting

How a Business’s Books Will Look Different Under the New Lease Accounting Standards

Oct 6, 2021 Michael Whitmire

Non-public entities were given a temporary reprieve from the new lease accounting standards, but the Financial Accounting Standards Board’s extension is about to come to an end. In just a few months, business leaders will need to be thinking about (and recording) leases differently. But there’s no need to stress; there is still plenty of time to get your books in order to comply with these new accounting standards.

Summary of the New Accounting Standards

In 2016, the FASB released Accounting Standards Update 2016-02 (ASU 2016-02), which called for significant changes to be made to the financial reporting standards for leases. Around the same time, the International Accounting Standards Board released its own version of lease reporting standards called International Financial Reporting Standards 16 (IFRS 16).

ASU 2016-02 led to the creation of Accounting Standards Codification Topic 842, Leases (ASC 842). These new reporting standards were initially set to be effective for nonpublic entities beginning in 2019. But the FASB has since delayed the effective date not once, but twice. These extensions are now expiring. Virtually all entities that follow generally accepted accounting principles – both public companies and private companies – must comply with ASC 842 on fiscal year reports that begin after Dec. 15, 2021, and on interim period reports that begin after Dec. 15, 2022.

The new standards affect lessees – those who lease assets to use in their business – and have less of an impact on lessors – those who own the assets and lease them to others. ASC 842 was created to improve the transparency of leased assets by including them on the face of lessees’ financials. Historically, most leased assets have lived off the balance sheet. 

The latest batch of lease accounting standards change a few things.

First, it redefines leases to be a contract (or a portion of a contract) that conveys the right to use or control an asset for a period of time in exchange for consideration. 

Second, it establishes three lease classifications for each lease contract: short-term, finance, and operating leases.

Short-term leases have lease terms less than 12 months in duration that do not automatically renew. 

Finance leases are long-term leases of assets that extend for most (if not all) of the useful life of the underlying asset.

Operating leases are leases longer than 12 months in duration for assets that will be traded in or upgraded regularly. For example, if your company leases a copy machine that gets upgraded every few years, that lease would be considered an operating lease.

Third, it establishes that finance and operating leases be recorded on the balance sheet while short-term leases can be kept off the balance sheet. Finance leases (previously known as capital leases) have always been recorded on the balance sheet, and will continue to be. Operating leases, which had previously been sequestered to the income statement, will now join finance leases on the balance sheet. They will be recorded as a “right of use” asset and a corresponding liability for the remainder of the lease payments.

How the New Lease Accounting Standards Alter a Business’s Books

The lease accounting standards do not require a business to change anything about its internal reports; the guidelines govern external financial reports. However, to produce accurate financial statements in alignment with ASC 842, your business’s books will almost certainly need to change.

Classify Your Leases Accurately

You will have an easier time preparing your financial statements if you record leases on your books in a way that aligns with ASC 842 reporting. Review your existing leases and classify them as one of the three lease types: short term, finance, or operating. From there, you can group like leases together. U.S. GAAP allows you to consolidate like leases for disclosure purposes. Typically, you can group leases if:

  • They are of the same nature.
  • You have applied the same assumptions and judgments.
  • They are used with the same related parties.
  • They have the same risks.

Adjust Your Monthly Accruals

Just like when operating leases were on the income statement, operating leases under the new accounting standards require monthly journal entries. However, those accruals will look different. Under prior accounting guidelines, you would have to record the following journal entries each month related to your operating leases:

Debit (DR): Lease Expense $XXX

Credit (CR): Cash/Accounts Payable $XXX

Under the new guidelines, your accruals would look a bit different. First, to establish the right-of-use asset on your balance sheet, you would record:

Debit (DR): Operating Lease Right-of-Use Asset $XXX

Credit (CR): Operating Lease Liability $XXX

Then, to record the monthly expense, you would book the following entry:

Debit (DR): Lease Expense $XXX

Debit (DR): Operating Lease Liability $XXX

Credit (CR): Cash/Accounts Payable $XXX

Credit (CR): Operating Lease Right-of-Use Asset $XXX

Separate Lease from Non-Lease Components

Contracts may include both lease and non-lease components. For example, a contract to lease a copy machine might also include costs for regular maintenance from the manufacturer. The lease may need to be separated from the service agreement on your financials. FASB does allow you to elect to group non-lease components in with a lease, but you must think about how a larger asset and liability balance will affect your financial statements. Artificially raising your asset balance for non-lease components could adversely affect key financial ratios that you need to secure financing or to meet existing debt covenants.

Draft Initial Journal Entries for the Transition

The journal entries you draft to transition to the new accounting standards will depend on whether your entity elects the FASB’s optional practical expedient for restating prior periods. Practical expedients help ease the reporting burden on businesses by allowing certain “shortcuts” on ASC 842’s initial reporting expectations. If you elect the transition practical expedient, you can apply the new lease accounting standards to only the most recent period and avoid remeasurement of prior periods. Instead of using your accounting software to post adjustments to comparative periods, you would post a cumulative adjustment as of Jan. 1, 2022 (for calendar-year entities).

Fully understanding ASC 842 will take time, and that’s OK. Like with ASC 606, the new revenue recognition principle, if you dedicate time to learn about the new standards and take measured action toward implementing the changes, your business can successfully adapt with time to spare.