ASC 2016-02 standard is effective for nonpublic entities for the calendar year 2022.

The effective date was changed from the calendar year 2021 as a result of the economic lockdown in late February 2020. All entities may choose to adopt the new standard early. All companies with lease agreements will be affected. Industries that could feel the impact of this updated standard include those with multiple locations (retail operations) and a significant investment in property, plant, and equipment (transportation companies).

Definition of a Lease

The definition of a lease is 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.” The customer controls an identified asset when the customer has the right to obtain all of the economic benefits from its substantial use and has the right to direct its use.

As of the lease commencement date, the lessee recognizes the following:
• Liability for its lease obligation (initially measured at present value for future lease payments)
• Asset for its right to use the underlying asset (ROU asset), which is equal to the lease liability adjusted for lease payments made at or before lease commencement, lease incentives, and any initial direct costs.

The classifications of leases are either an operating lease or a finance lease. The lease classification criteria are as follows:
• Lease transfers ownership to the lessee by the end of the lease term
• Bargain purchase option which the lessee is reasonably certain to exercise
• Lease term is for a major part of the remaining economic life of the underlying asset
• Present value of the sum of lease payments and any guaranteed residual value equals or exceeds substantially all of the fair value of the underlying asset
• Underlying asset is of such a specialized nature; it has no alternative use to the lessor at the end of the lease term.

Expense short-term lease payments may as incurred. A lessee can elect (by asset class) not to record on the balance sheet if the term of the lease is 12 months or less, and the lease does not include a purchase option that the lessee is reasonably certain to exercise. Take consideration for the short-term lease exception in the case of a renewal option which the lessee is reasonably certain to exercise.

Lessees and lessors are required to account for related-party leasing arrangements on the basis of the legally enforceable terms and conditions of the lease rather than the substance of the arrangement. This change is significant in contrast to the current U.S. GAAP, under which a lessee and lessor would consider the substance of the contract as well as its legal form.

Example:
Lease term 3 years (no renewal option)
Economic life 5 years
No purchase option
Rent payments $100, paid in arrears, escalating $3 annually
An interest rate of 7%
The fair value of the asset = $500
Present value of lease payments = $270

Operating Lease

Initial recognition entry

Debit – Right-of-use asset for $270
Credit – Lease liability for $270

Operating Lease

Operating Lease Entry

Year 1 Entry to record the lease payment and expense
Debit – Lease expense for $103 A
Debit – Lease liability for $81 D
Credit – Cash for $100 B
Credit – Accumulated amortization for $84 A-C

Finance Lease

Initial recognition entry

Debit – Right-of-use asset for $270
Credit – Lease liability for $270

Finance Lease Entry

Year 1 Entry to record the lease payment and expense
Debit – Interest expense for $19 C
Debit – Amortization expense for $90 A
Debit – Lease liability for $81 D
Credit – Cash for $100 B
Credit – Accumulated amortization for $90 A

Disclosures:
• Nature of its leases
• Information about the lease that has not yet commenced
• Related-party lease transactions
• Accounting policy election regarding short-term leases
• Finance and operating lease costs
• Short-term and variable lease costs
• Sublease income
• Gain or loss from sale and leaseback
• Maturity analysis for lease obligations
• Weighted-average remaining lease term
• Weighted-average discount rate

Tax Impact

The new lease standard is a GAAP effect. It has no bearing for tax purposes. Only deduct rent for the amount paid that applies to the use of the rented property during the tax year (Pub 535). In other words, only include 12 months of rent payments on page 1 of the business return. Accordingly, include the cash payments for the rent/lease on page 1, and apply the difference of the payments to M1.

Your business may have experienced financial fluctuations in the last 12 months, and you are trying to decipher how new standards and legislation affect your business. Now is the time to consider leaning on your accountant for cash flow guidance, tax deadlines, completing loan applications, tax credit calculations, and interpreting legislation. Our accountants are available, and we have the knowledge, skill, and information that you need right now to address your financial needs in a timely fashion adequately. Contact us today.

By Amy Kletch, CPA

Amy is a manager with over 20 years of audit experience in various industries, including public companies, non-profits, manufacturing, distribution, construction, government, oil and gas, pension plans, and transportation.