Scott Levy – Head of Accounting Advisory Group
On June 16, the Financial Accounting Standards Board (FASB) issued a proposal that would enable private companies to have a more flexible approach when using a discount rate to measure lease liabilities. The discount rate directly impacts the lease liability that companies record on their balance sheets, and the proposed tweak would be a helpful simplification.
Updated lease rules
Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), is the culmination of years of debate about how to make balance sheets more representative of companies’ financial conditions. The updated guidance requires companies to report on their balance sheets their leased office space, storefronts, vehicles and equipment as assets and the rent they pay for them as liabilities. In addition, lessees will need to expand disclosures about the terms and assumptions used to estimate their lease obligations, including information about variable lease payments, options to renew and terminate leases, and options to purchase leased assets.
The updated guidance applies to all lease arrangements with terms of more than 12 months. However, companies can elect to also capitalize leases with terms of 12 months or less.
The rules took effect in 2019 for public companies. Calendar-year private companies that follow U.S. Generally Accepted Accounting Principles must comply with the updated lease rules in 2022.
Implementation starts by gathering all contracts and assessing who’s in control. Most businesses will know right away that they have to put their rented real estate, factory equipment and vehicle fleets on their balance sheets. But some arrangements can get more complex.
In some cases, deciding whether to report leases on the balance sheet could require complex judgment calls. The updated rules will require management to cull data not just from rental agreements for storefronts and vehicles, but also from service arrangements and third-party outsourcing contracts.
When implementing the changes, private companies have the option of using a risk-free rate to measure lease liabilities. But that election must be made for the entire lease portfolio.
Proposed ASU 2021-003, Leases (Topic 842) — Discount Rate for Lessees That Are Not Public Business Entities, would allow private companies to elect to use the risk-free rate, as opposed to an incremental borrowing rate, at an underlying asset class level rather than having to elect it for their entire portfolio of leases. Under the proposal, if the election is made, the entity would need to disclose that in their footnotes.
For example, the proposal would allow a company to use the risk-free rate for vehicle leases, and then choose the incremental borrowing rate for larger real estate leases. The FASB proposed this practical expedient in response to private company concerns raised during a 2020 roundtable discussion.
This proposal comes at a key time for private companies as many are still gearing up to adopt the updated guidance on leases. If finalized as proposed, the effective date of the proposed change would vary.
Specifically, companies that haven’t yet adopted ASU 2016-02 would apply the proposal when they adopt that standard. Those that have already adopted ASU 2016-02 would apply the proposed change to fiscal years after December 15, 2021, and interim periods within fiscal years after December 15, 2022. Earlier application would be permitted. The changes would be required on a modified retrospective basis to leases that exist at the beginning of the period of adoption of a final standard. Contact your CPA for more information on how the changes, if approved, would affect your balance sheet and footnote disclosures.
Sidebar: FASB updates rules for leases with variable payments
On July 19, the Financial Accounting Standards Board (FASB) issued an accounting rule that requires sales-type leases with payments that vary to be recorded as operating leases. This change will enable companies to avoid booking a loss on profitable contracts.
Specifically, Accounting Standards Update (ASU) No. 2021-05, Leases (Topic 842): Lessors — Certain Leases with Variable Lease Payments, requires lessors to classify and account for a lease with variable payments as an operating lease if:
· The lease would have been classified as a sales-type lease or a direct financing lease, and
· The lessor would have otherwise recognized a day-one loss.
The resulting information will improve the usefulness of the information to financial statement users.
The changes are effective for fiscal years beginning after December 15, 2021, for all entities. They’re effective for interim periods within those fiscal years for public companies and interim periods within fiscal years beginning after December 15, 2022, for private companies and other entities.