New Lease Standards impacting Portfolio Companies
1. Do I have to apply this standard if I report my financial statements on a tax basis of accounting or any other special purpose framework?
Entities who report under a special purpose framework are not required to comply with the requirements in Topic 842 unless the framework dictates this accounting standard should be followed. In addition, it’s important to note that U.S. GAAS and the SSARS require that when special purpose financial statements contain items that are the same as, or similar to, those in financial statements prepared in accordance with U.S. GAAP, those financial statements should include informative disclosures similar to those required by U.S. GAAP.
2. What type of arrangements are in scope and out of scope for this new standard?
The criteria for determining whether an arrangement meets the definition of a lease under Topic 842 are similar to Topic 840. As a reminder, a lease is defined as a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.
If the lessee does not have the right to control the use of an identified asset, then the arrangement may not qualify as a lease.
Furthermore, Topic 842 does not apply to any of the following, which are covered by other accounting guidance:
- Leases of intangible assets [includes software] (see Topic 350, Intangibles — Goodwill and Other)
- Leases to explore for or use minerals, oil, natural gas, and similar nonregenerative resources (see Topics 930, Extractive Activities — Mining, and 932, Extractive Activities — Oil and Gas)
- Leases of biological assets, including timber (see Topic 905, Agriculture)
- Leases of inventory (see Topic 330, Inventory)
- Leases of assets under construction (see Topic 360, Property, Plant, and Equipment)
3. I only have a few “small” leases. Do I really have to apply this new standard if I believe the impact will not be significant to my organization?
Topic 842 does not contain a specific materiality threshold for the recognition of a lease; however, paragraph BC122 of ASU 2016-02 states: “Entities will likely be able to adopt reasonable capitalization thresholds below which lease assets and lease liabilities are not recognized, which should reduce the costs of applying the guidance. An entity’s practice in this regard may be consistent with many entities’ accounting policies in other areas of GAAP (for example, in capitalizing purchases of property, plant, and equipment).”
This materiality consideration should take into account the purpose of the standard while also weighing reporting that is meaningful to the readers of the financial statements.
4. I have short-term leases; do I have to apply this new standard to them?
A lessee can elect (by asset class) for short-term leases not to record on the balance sheet a lease that, at the commencement date, has a lease term that is 12 months or less and does not include a purchase option that the lessee is reasonably certain to exercise. The 12-month threshold for the short-term lease exemption is a bright-line exception to the lessee recognition requirements in Topic 842. This accounting policy, if elected, would be applied by underlying asset class and would result in a lessee’s recognition of its lease payments in profit or loss on a straight-line basis over the lease term and variable lease payments in the period in which the obligation for those payments is incurred. Judgement should be exercised when assessing this exemption as a variety of facts and circumstances may impact the ability of the entity to qualify for this exemption.
5. I have related-party leases, what is the big deal about these?
Prior to the adoption of Topic 842, related parties were required to consider the economic substance of related-party arrangements. Economic substance relates to the underlying economic or commercial purpose of a business transaction verses its legal form. Topic 842 now requires related parties to consider the legal enforceability of related-party arrangements. It is expected that legally enforceable terms and conditions will typically be determined by the terms included in a written contract. This change in concept results in additional complexity regarding verbal contracts and written contracts with the potential for cancelation.
With the adoption of Topic 842, the accounting treatment for leases will be tied more closely to legal arrangements with less room for judgment around the substance of transactions that was used prior to Topic 842.
Other important reminders
What changed?
Prior to Topic 842, entities were only required to recognize leases classified as capital leases (now financing) on the balance sheet. For leases classified as operating leases, payments were reflected in the financial statements as rent expense on the income statement and the lease commitments were included in the disclosures of the financial statements.
The core principle of Topic 842 is that all leases (with minimal exceptions for certain leases) create an asset and a liability for the lessee. A lessee should recognize a liability to make lease payments (the lease liability) on the balance sheet and a right-of-use asset representing its right to use the underlying asset for the lease term.
When do I apply?
| Public business entities or nonprofits that have issued, or are a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market | Annual periods beginning after December 15, 2019 (e.g., December 31, 2020, year-end) and interim periods therein |
|---|---|
| Other entities | Annual periods beginning after December 15, 2021 (e.g., December 31, 2022, year-end) and interim periods within fiscal years beginning after December 15, 2022 |
How we can help
CLA can come alongside your organization and support your lease standard compliance efforts. We provide three main options, which can be customized for your needs.
Option 1 — Entity performs full assessment
- CLA provides preparation resources to assist with your Topic 842 implementation
- CLA assesses management’s adoption and disclosures
Option 2 — CLA new accounting standard assessment
- CLA provides preparation resources to assist with your Topic 842 implementation and explains how it applies to your organization
- CLA interviews your key team members; reviews a selection of potential leases; assists with evaluating the accounting for the leases; proposes adjusting entries; and assists in drafting financial statement disclosures
Option 3 — CLA turnkey lease approach
- CLA provides preparation resources to assist with your Topic 842 implementation and explains how it applies to your organization
- CLA works with you on the leases you have identified to guide you through the decision process regarding how the leases will be accounted for
- Based on management’s decisions, CLA will prepare lease asset schedules; propose journal entries to record the various elements into your general ledger; and prepare draft financial statement disclosures
Craig Arends is a principal at CLA and is the managing principal of CLA's private equity practice. Craig brings a concentration of experience in providing accounting and transaction structuring advice for leveraged recapitalizations, purchase accounting and SEC reporting, assessing quality of earnings, and GAAP accounting. He has far-reaching experience with critiquing financial models and reviewing target companies' financial performance to identify cost reductions and/or operating efficiencies Craig has more than 30 years of experience in public accounting serving public companies, private equity groups, and companies, including a term as principal in charge of a Big Four Capital Markets Group in Moscow, Russia. He has led financial accounting due diligence projects for private equity investor groups and venture capital funds, primarily in the technology, communications, and manufacturing industries, as well as assisting with Foreign Corrupt Practice Act matters ranging from investigation of payments made, validation of compliance with corporate policies, and review of proposed transactions to ensure compliance. When not working, Craig enjoys watching any sports, but his most favorite are baseball, football and soccer.
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