The Basics of the New Lease Standard for Organizations with Fiscal Years Ending in 2023 that Have Not Implemented

While the new lease accounting standard has been with us for several years, ASC 842, Leases, became effective for non-public reporting entities with years ending after December 15, 2022. This means that all organizations required to issue financial statements in accordance with accounting standards generally accepted in the United States (GAAP) with years ending December 31, 2022 and all months in 2023 through 12/15/23, must now present their financial statements in compliance with ASC 842.

We have seen that many smaller organizations with fiscal years ending in 2023 did not proactively analyze and implement the standard. For example, many non-profits have a June 30^th year-end and with June 30, 2023 now behind us, some organizations are now realizing that the new lease accounting standard must be implemented for their FY23 financial statements to be in accordance with GAAP.  As a result, many are seeking immediate outside help before their deadline to issue audited financial statements.

Most lessees understand that all long-term leases must now be on the balance sheet or statement of financial position, and most are aware of the new Right-of-Use (ROU) Asset and corresponding lease liability that must now be calculated and presented. However, how do we get these amounts and what about the ongoing accounting throughout the lease term? Our audit and assurance team continues to receive a steady stream of prospective clients who are seeking help to get the new standard implemented. While many of the specifics within the standard are quite detailed and have some complexity, based on the most common questions and inquiries, the Stone accounting team decided to present a plain-English version of the accounting requirements under ASC 842 and their impact on the financial statements for those who want a basic overview of the now effective accounting requirements for leases under GAAP.  

What are the basic steps to get to the correct accounting under ASC 842?

There are essentially four steps for accounting for leases under ASC 842.

1.     Find the present value of the lease payments

2.     Calculate the interest and principal payments

3.     Determine if the lease is an Operating or Finance lease

4.     Account for your lease (Record your initial and ongoing journal entries)

What’s my initial entry to bring the lease onto the books and record this new ROU asset?

The ROU Asset will be the same as the present value of the lease payments, except that this amount must be increased by any initial direct costs paid by the lessee, and increased by any prepaid lease payments. This ROU asset will also be reduced by any lease incentives received. As such the initial journal entry may be summarized as follows:

             
Dr. ROU Asset: PV of lease payments 

 + initial direct costs

+ prepaid lease payments

 - lease incentives received

         Cr. Lease Liability: PV of lease payments

         Cr. Cash: Cash paid in connection with lease

The new lease standard has new terms that seem to have different meanings from the previous terms “capital” versus “operating” leases under the old standard.  Under the new standard, what do these terms, Operating versus Finance, mean?

Under ASC 842, all long-term leases must now be treated as Operating leases, except for when the following condition exists, in which case, the lease must be accounted for as a Finance lease: “When the terms of the lease effectively transfer control of the underlying asset”.  

So how does one determine whether the terms of the lease effectively transfer control of the underlying asset?

If any one of the following five conditions exist, the lease must be accounted for as a Finance lease”

1.     The lease transfers ownership at the end of lease

2.     An option to purchase is reasonably certain

3.     The lease term is a major part of the leased asset’s useful life

4.     The present value of the lease payments plus any lessee residual value guarantee equals
         substantially all of the fair value of the leased asset

5.     The leased asset is specialized, with no alternative use to the lessor 

        Conditions 3 and 4 mention some terms that seem vague. What do we mean by “major part” of the
        economic life and “substantially all” of the fair value?

A lease term is a “major part” of the economic life when it is 75% or more of the remaining economic life of the underlying asset. A commencement date that falls at or near the end of the asset’s economic useful life would be considered to be within the last 25% of the total economic life.

The present value of lease payments is “substantially all” of the fair value of the underlying asset when it is 90% or more of the fair value of that underlying asset.

Why is there so much concern about the new lease standard and how does it affect the financial statements?

All long term leases must now be presented on the balance sheet and the type of lease (Operating versus Finance) affects the accounting and financial reporting in very different ways. Whether a lease is categorized as operating or finance (a) affects how the ROU asset is expensed, (b) affects the presentation on the statement of cash flows, and (c) impacts the ROU asset balance throughout the lease term. Additionally, operating leases can negatively impact financial debt covenants. Ratios such as current ratio, quick ratio and return of assets might now be in violation of loan covenants, since the liability will have a current position but not the ROU asset, in addition to the increase in an organization’s overall liability and increase in its total assets.

Your Stone & Company audit and assurance team will remain a key resource for our non-profit community as organizations navigate these new presentation and disclosure requirements. Contact us for additional information and assistance or to further discuss how the new standard might impact your organization.

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Bob Page, CPA, contributed to this article. - Stone & Company, LLC, Lexington, Massachusetts - www.stonecpas.com