Matter & Substance
  October 27, 2021

ASC 842 and Operating Leases

Part 2: The new least standard is coming. Learn how this will impact your Operating Leases.
Please note, if applicable, your M&S Advisor will reach out soon to ensure the implementation of this new standard.

The New Lease Standard... Coming (really) soon!

You’ve probably heard rumblings about the FASB’s new accounting and reporting standard for leases – Accounting Standards Update No. 2016-02, Leases (Topic 842).  This new standard will become effective for non-public business entities for fiscal years beginning after December 15, 2021. This standard requires companies to include more leases than ever on their balance sheet.

For many of our clients, implementation may require significant investment(s), attention, and leadership time. 

In our previous article, "New Lease Standard is Coming (really) soon!" we covered the basics of the analysis and accounting behind the new standard. 

ASC 842 will not significantly change the manner in which finance leases are recorded, but will have a large impact on the manner in which operating leases are recorded. Today we will discuss how to determine which type of lease you have, and the impact of the new standard.

Is it an operating lease?

ASC 842 will not significantly change the recording of finance leases. However, the tests in determining the lease classification have changed. The first step is to identify which of your leases may be finance and which are operating.  Each lease must go through five tests to determine its classification. The five tests are:

  • Will the ownership or title of the asset be transferred to the lessee when the lease term ends?
  • Is the lessee reasonably certain to exercise an option to purchase the underlying asset?
  • Is the lease term a major part of the remaining economic life of the underlying asset?
  • Does the present value of the sum of the lease payments, including any residual value guaranteed by the lessee, exceed substantially all of the fair value of the underlying asset?
  • Does the underlying asset have such a specialized nature that it has no alternative use to the lessor at the end of the lease term?

If a lease does not meet any of the above conditions, it is classified as an operating lease under the new ASC 842 standard.

Why is this change necessary?

A reminder, the purpose of ASC 842 is to bring most operating leases, which are currently accounted for off-balance sheet, onto the balance sheet.

This will provide financial statement users a more realistic view of the lease obligations of an individual company. This may be particularly important for those looking to buy, sell, or invest in an organization.

What should I do right now?

ASC 842 may impact the debt and credit arrangements you have with your lenders. In fact, while the health of your business may not change – the updates to your financial statements could have a significant and negative impact on your debt ratios. In the most severe cases, this could trigger a “default” on your debt agreements.

In addition to discussing the changes with your M&S Advisor, we recommend reaching out to your lenders and banking partners to discuss how your financial information will be used and what potential impact the new standard will have.

Specially, you and your partner should:

  1. Review any clauses in your current agreements preventing default from the GAAP adoption
  2. Renegotiate loan agreements to accommodate the impact of ASC 842

Obtain an incremental borrowing rate used to calculate the value of your lease and obligations.

We are here for you

As things continue to evolve, we will be here to guide you through any changes or questions. Our office has started to reopen. All clients can now safely join us in person or we can meet with you remotely, depending on your preference.