New lease accounting standard

As of Jan. 1, 2022, the Financial Accounting Standards Board (FASB) lease accounting standard, Accounting Standards Codification (ASC) 842, “Leases,” became effective for many private companies, requiring lessees to recognize most leases on their balance sheets. But many organizations still have questions about how to get up to speed on preparation and compliance.

The most significant change under this new guidance is that lessees now need to recognize a lease liability and corresponding right-of-use (ROU) asset for those leases previously classified as operating leases. Consequently, all leases, whether finance or operating, now will be on balance sheet unless they are subject to the short-term lease accounting policy election. A lessor’s accounting for direct-finance, sales-type, and operating leases under the new standard is similar to existing GAAP.

For lessees, most capital leases under existing GAAP will be accounted for as finance leases under the new standard. Similarly, most operating leases under existing GAAP will remain operating.

Under the new standard, a lessee evaluates whether a lease is classified as finance or operating at the commencement of a new lease and upon a change in the lease term or change in the lessee’s option to purchase the asset. The criteria for classifying a lease is, in most cases, generally consistent with existing GAAP.

The differences in lease classification are outlined in the following table: 

Q: What does an ROU asset mean in accounting?

A: While most of the focus of ASC 842 revolves around the fact that lessees are reporting a lease liability representing the future lease payments, many stakeholders have asked, “What is an ROU asset, and how is it accounted for?” The ROU asset represents the lessee’s right to control the use of the underlying lease asset for a period of time. Under U.S. GAAP, the ROU asset is considered a long-lived asset that is accounted for following Topic 842’s initial and subsequent measurement guidance. Lessees also must evaluate the ROU asset for impairment in accordance with Topic 360, “Property, Plant, and Equipment,” which broadly applies to other long-lived assets.  

Q: How is the ROU asset initially measured?

A: The ROU asset’s initial measurement is based on the initial measurement of the lease liability, plus any lease payments made to the lessor at or before lease commencement, less any lease incentives received, plus any initial direct costs incurred by the lessee.

Q: How is the ROU asset measured upon initial adoption of Topic 842?

A: The answer depends on how the lease is classified and whether the package of transition practical expedients is elected. Most entities are expected to elect to use the package of transition practical expedients, in which case an entity’s classification of its existing leases is not reassessed. Entities that elect to apply the package of transition practical expedients should initially measure the ROU asset as follows:  

The transition adjustment, in most cases, is largely a balance sheet gross-up. Entities with significant balances of lease incentives, deferred rent, and/or obligations under Topic 420, “Exit or Disposal Cost Obligations,” at the transition date should keep in mind that these balances are, in most cases, merely reclassified on the balance sheet in establishing the initial ROU asset. That is, in most cases, the balances are not derecognized or adjusted through a cumulative effect adjustment to equity. 

Q: Can the ROU asset exceed the fair value of the underlying asset?

A: Yes, unlike the old lease guidance for capital leases, Topic 842 does not prohibit this scenario. However, entities in this position should assess the accuracy of their lease measurement assumptions, such as the discount rate, identification of lease and nonlease components (if applicable), and allocation of contract consideration between the lease and nonlease components (if applicable).

Q: How is the ROU asset subsequently measured?

A: The answer depends on whether the lease is classified as a finance lease or an operating lease, as follows:

Q: How is the ROU asset of an operating lease subsequently measured after an impairment?

A: After an impairment, the ROU asset reverts to being amortized over the remaining lease term on a straight-line basis. 

Q: How are lease incentives subsequently accounted for?

A: As previously described, the subsequent measurement of an operating lease’s ROU asset is largely a “plug” for the difference between the lease’s straight-line lease cost and the change in the lease liability (that is, the accretion of the liability based on the discount rate less lease payments made during the period). Consequently, lease incentives that were recognized upon initial measurement of the ROU asset subsequently are adjusted through the adjustment to the ROU asset.

Topic 842 is silent regarding how to account for contingently receivable lease incentives that are expected to be received after the lease commencement date (for example, a buildout allowance provided by the lessor after the lessee incurs buildout costs). More than one acceptable approach exists to account for lease incentives that are neither paid nor payable at lease commencement; however, the approach depends on the facts and circumstances of the lease incentive’s terms and conditions. Entities should evaluate the terms and conditions of significant lease incentives and discuss their approach with individuals responsible for accounting policy decisions and governance, as well as with their accounting advisers or independent accountants, as applicable. 

Q: What are some other examples of when the ROU asset might be subsequently adjusted? 

A: Besides applying the subsequent measurement guidance previously described and evaluating the asset for potential impairment in accordance with Topic 360, entities need to consider the impact to the ROU asset when the following events or conditions take place:

• A modification is made that does not grant the lessee an additional ROU asset at a market rate, including a partial termination of the lease. Topic 842 introduces a more robust framework to account for lease modifications than prior GAAP. 
• The lease is fully terminated before the expiration of the lease term. 
• A remeasurement triggering event occurs, as outlined in the following table: 

Q: What are some examples of circumstances that might necessitate an impairment evaluation under Topic 360?

A: Applying the impairment model in Topic 360 can be a complex assessment for lessees. To start, an impairment evaluation under Topic 360 is performed at the asset group level. Determining asset groupings can require considerable judgment. Next, a lessee performs an impairment test only when events or changes in circumstances (that is, triggering events) indicate the carrying amount of the asset or asset group might not be recoverable. If triggering events are present, the lessee performs a two-step impairment test, as follows: 

• Step 1: Recoverability test. Compare the carrying amount of the asset or asset group to the sum of the estimated undiscounted future cash flows attributable to the asset or asset group. If the carrying amount exceeds the undiscounted cash flows, Step 2 of the impairment test must be performed. 
• Step 2: Measuring an impairment. An impairment loss is recognized if the carrying amount of the asset or asset group exceeds its fair value. 

Performing the two-step impairment test can be another complex undertaking requiring management to use considerable judgment in its estimates and assumptions. Here are some examples of when a lessee should consider whether an impairment triggering event has occurred: 

• The lessee has completely abandoned the leased asset by permanently ceasing its use with no right or intent to sublease the asset. 
• The lessee plans to abandon the leased asset, which also might prompt the need to reassess the lease term – and consequently lease classification. 
• The lessee subleases (or decides to sublease) the leased asset. 
• The lessee changes (or plans to change) the fundamental use of the leased asset. 

Q: Will adopting Topic 842 change working capital?

A: By recognizing operating leases on the balance sheet, an entity will add to the balance sheet a lease liability – classified between current and noncurrent, with the corresponding ROU asset classified as a long-term asset. Consequently, holding all other variables equal, working capital will be lower after adopting Topic 842.  

Some companies might have concerns about a perception of additional leverage with ROU assets and operating lease liabilities now on the balance sheet. However, several mitigating factors exist, including these¹: 

• Topic 842 characterizes operating lease liabilities as operating liabilities instead of debt and therefore typically should not affect most debt covenant calculations. 
• Many credit agreements contain “frozen GAAP” provisions that indicate that changes in GAAP will not constitute a default or will require both parties to negotiate in good faith if technical default occurs as a result of the adoption of new GAAP. 
• Banks with whom the FASB conducted outreach indicated they are unlikely to “call a loan” with a good customer because of a technical default arising solely from the adoption of new GAAP. 
• The extended effective date provides additional time for companies to modify agreements to the extent necessary. 

¹ Accounting Standards Update 2016-02, “Leases (Topic 842) Section C – Background Information and Basis for Conclusions,” paragraph BC14, FASB, https://fasb.org/jsp/FASB/Page/SectionPage&cid=1176156316498