ASC 842 Lease Accounting Background
The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02 in February 2016, superseding and making several changes to lease accounting guidance under Topic 840. These changes included requiring the recognition of right-of-use (ROU) assets and a corresponding lease obligation on the entity’s balance sheet as a finance or operating lease.
What is the Goal of ASC 842?
Considering how prevalent property, plant, or equipment leasing is to most businesses, the overarching goal of these standards is to enhance transparency into liabilities, reduce off-balance-sheet activities, and increase comparability among entities. This goal is achieved by recognizing leases on the balance sheet and providing more information about leasing arrangements.
ASC 842 Effective Date
Now, Accounting Standards Codification (ASC) Topic 842 (also known as ASU Update 2016-02, Leases) is applicable for the fiscal year and interim periods beginning after December 15, 2021, for private companies. Public companies had a different effective date for interim periods within fiscal years beginning after December 15, 2018. Topic 842 was effective starting in 2022 and brings about significant changes to reporting requirements and balance sheets as well as various implications to a company’s financial statements, taxes, Federal Acquisition Regulation (FAR) Part 31 Contract Cost Principles and Procedures compliance, and M&A transactions.
Are There Any Exceptions?
Topic 842 applies to many leases and subleases, however, there are certain exceptions. The out-of-scope lease types as detailed in guidance are as follows:
- Lease of intangible assets.
- Lease for the use or exploration of non-regenerative natural resources.
- Lease of biological assets.
- Lease of inventory, covered under ASC 330 Inventory.
- Lease of assets under construction, covered in ASC 260 Property, Plant, and Equipment.
Lease Accounting Under ACS 842
Similar to ASC 840, the new ACS 842 lease accounting standard features a two-model approach for lessees. This means each lease can be classified as either a finance or operating lease. This is applicable to all leased asset categories that are covered under the new standard which includes leases of equipment and real estate. Therefore, the “finance lease” term replaces “capital lease” which was used under Topic 840. As such, Topic 842 changes the definition and criteria of a finance and capital lease.
Government contractors are encouraged to review these new standards to mitigate potential resource constraints upon implementation. Furthermore, the navigation of disclosures, financial and tax implications, cost allowability, and M&A implications present another hurdle. Contractors can contact Ryan & Wetmore today to further discuss these challenges and impacts.
Impact on Government Contractors
Topic 842 has raised many concerns within the contracting community. From cost allowability of rental expense under FAR Part 31 to tax implications, it is now more important than ever to begin implementing this new guidance.
ASC 842: FAR Part 31 Implications
The allowability of costs under the new standard has been a concern for government contractors. Under Topic 842, rent expense recorded under operating leases and amortization expense related to the ROU asset under finance leases will be allowable when calculating indirect rates. Consistent with past capital lease accounting standards, interest expenses under finance leases remain unallowable.
ASC 842: Financial Statement Implications
This new standard presents a notable change as it requires almost all leases to be recognized on the balance sheet of a lessee’s financial statement. This means ROU assets and lease liabilities are to be recognized, potentially impacting financial covenants and key performance metrics including Return on assets, debt to equity ratio, interest coverage or operating coverage.
It is important for contractors to consider the effect of Topic 842 and to discuss any upcoming issues with their bankers, investors, and financial advisors prior to interim or year-end reporting. For short-term leases of 12 months or less, lessees can elect to not recognize lease assets and liabilities. This exemption is only applicable for lessees, not lessors.
All lease activities will be reported on the income statement, consistent with the prior lease accounting standard. For operating leases, lease or rent expenses are recognized on a straight-line basis over the term of the lease. For finance leases, amortization expenses are recognized over the ROU asset life, with a separate interest amount that accrues on the liability.
Under finance leases, repayments of the principal portion of a lease fall under financing activities on the cash flow statement, whereas interest payments and variable lease payments fall under operating activities. Under an operating lease, all cash payments for leases will be classified under operating activities.
Disclosures have changed substantially under Topic 842. The required disclosures include but are not limited to:
- Description of the lease.
- Terms for variable lease payments and terms for options to extend or termination of the lease. This includes terms that are both included in the measurement of ROU assets and lease liabilities and that are not.
- Terms of purchase options.
- The determination of the discount rate for the lease.
- Lease and non-lease components and the allocation of consideration between these.
- Separately reporting interest on the lease liability, amortization of ROU assets, and operating lease costs.
ASC 842: Tax Implications
Topic 842 will not have an impact on the federal income tax treatment of leases. Leases will still either be treated as a true-tax lease or a non-tax lease. Under a true-tax lease, lessors maintain asset ownership and related deductions such as depreciation expense over the life of the asset. Under a true-tax lease, the lessee would deduct rent when paid. This means that non-tax leases place the risks and rewards of ownership on the lessee. Thus, tax deductions, such as interest or depreciation expense, are booked by the lessee. On the other hand, the lessor recognizes interest income.
Companies who have adopted or are planning to adopt Topic 842 should analyze how implementation will affect other non-income-based taxes. Certain property tax liabilities may change as a result of this standard. Furthermore, companies are encouraged to review any sales and use tax impacts. Consideration will need to be given to the deferred tax accounting related to the timing differences between book and tax accounting of leases.
ASC 842: M&A Implications
Businesses considering going through an M&A transaction are encouraged to review the various impacts to financial statement reporting and financial ratios, which will be analyzed during transaction due diligence. Topic 842 will bring about more transparency for a company’s leverage, impacting certain deal metrics in an M&A transaction. Under this new lease standard, certain businesses are required to recognize some current liabilities, thereby increasing debt and debt-like items.
Furthermore, a current asset will not be created, impacting your business’s working capital ratio. Financial ratios such as Return on Assets (ROA) will also be impacted as assets are set to increase. On the Income Statement, operating leases will see a reduction, partially offset by an increase in depreciation and interest. Free cash flow will be impacted as the principal component of lease payments will fall under financing activities. Through all this, moving leases onto the balance sheet will essentially replace the lease expense on the income statement with interest and depreciation (which falls after the EBITDA line).
It is also important to note the cash flow impact of lease treatment as there are varying opinions on how interest and depreciation impact a company’s EBITDA from being an add-back by definition, or a non-add-back from a cash flow perspective.
For example, certain leases will trigger the capitalization and depreciation of a ROU asset, altering EBITDA. As leases pertain to quality of earnings, the income statement presentation of operating leases presents a significant difference as operating lease costs will be a deduction from EBITDA.
ASC 842 Lease Accounting Implementation Considerations
As ASC 842 lease accounting is now in effect for private company financials after December 15, 2021, and changes are effective for the 2022-year end, it is now more important than ever to begin the implementation process. Waiting until the end of the year brings about other issues in addition to compliance. Consider interim financial reporting, monthly or quarterly loan covenants.
Topic 842 was effective January 1, 2022, with the first annual reporting date on December 31, 2022. The first quarterly reporting date (if required) is March 31, 2023.
Contractors are encouraged to perform the following activities to remain compliant ahead of these changes:
- Centralize, review, and manage existing lease agreements.
- Understand whether your lease is classified as short-term, finance, or operating.
- Understand the timing of rental income or expenses.
- Develop a process to separate lease components from non-lease components.
- Establish internal management and control procedures.
- Review and discuss with your lender or banker the implications of this new standard.
- Consider internal resources within the accounting department and whether speaking with an expert will make the transition smoother.
As Topic 842 brings about a new layer of reporting and compliance requirements, businesses may face internal resource constraints (especially within the accounting department) when implementing the new ASC 842 lease accounting standard.
Companies can contact Ryan & Wetmore today for assistance regarding financial reporting and tax implications. Furthermore, speaking with experts will streamline any implementation hurdles faced within your departments. Being proactive and adhering to this new standard will aid government contractors in adjusting and navigating this changing environment.
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About Tessa Lucero-Bennett
Senior Manager, CPA, & MBA
Tessa is a Senior Manager at Ryan and Wetmore. Tessa has over 20 years of experience serving and advising businesses in all phases of the organizational life cycle. Her experiences range from traditional accounting and tax services to complex consulting services, including business planning, financial budgets and projections, benchmarking and financial trends, M&A support and analytics, internal controls assessment, development of best business practices, and financial training for top management levels.
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About Rosie Cheng
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Peter T. Ryan co-founded Ryan & Wetmore in 1988 with business partner Michael J. Wetmore. Peter provides clients with the best strategies for success. His expertise extends across various industries, including government contracting. Peter obtained a Master of Business Administration in Finance from the University of Baltimore and a Bachelor of Arts in Accounting from the Catholic University of America.
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