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Lessees: A Few Items to Consider with ASC 842 Implementation

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Now that ASC 842 has been implemented, what are some things that lessees may have not completely considered? This article discusses a few areas that should continue to be considered by lessees when implementing the new lease standard.

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ASC 842, Leases, impacts all companies with leases – in all industries.  Implementation requires participation throughout the company; it’s not limited to the accounting and finance personnel.  To say the impacts of the changes related to ASC 842 are broad is an understatement. That said, what are some items that companies may not be considering with regard to the implementation of the new standard?  

We are starting to see some issues evolve as filers are implementing the standard.  What should your company be aware of?  What are some other areas impacted by the new standard that may not have been a focus during implementation efforts?

Certainly companies are aware of the need to separate lease and non-lease components, the need for additional resources or technology, global systems impacts, and the need to report operating liabilities on the balance sheet as all areas of focus with regard to implementation of ASC 842.  A few areas or items that perhaps companies have not focused on may include identifying embedded leases and understanding the impact to existing debt covenants.  

Lessees will now report a new liability for operating leases separately from debt with capital leases or loans for purchased assets and a right-of-use (RoU) asset representing the lessee’s right to use the underlying asset for the lease term on the statement of financial position.  Because of this change in reporting, it is estimated that 3 trillion dollars of RoU assets and lease payment liabilities will be placed on U. S. reporting entities’ statements of financial position, according to the International Accounting Standards Board.  With that, a lessee’s financial metrics will change, for example, debt to equity will increase and interest coverage will decrease.  A lessee’s financial performance metrics will also change, for example, EBITDA will increase, return on assets will decrease, and the current ratio will decrease.  Loan covenants and other longer term contractual credit arrangements may be violated based on the addition of RoU assets and lease payment liabilities on the statement of financial position.  

With respect to embedded leases, lessees will need to conduct analysis for embedded leases contained within service contracts that were not previously accounted for as leases. Additionally, this analysis should include identifying the lease and non-lease components of the arrangement. Lessee’s lease accounting systems or teams will need to account for these components separately.  If the company cannot effectively account for the components separately, a practical expedient may be elected in the form of an accounting policy election to account for them as a single combined lease component, but this election must be made by class of underlying asset (i.e. real estate, automobiles, etc.).  

The intention here is to reduce the burden of having to track and account for the components separately.  However, this election will result in a gross up of the statement of financial position should the non-lease components be significant; this happens as a result of the non-lease components being included in the measurement of the RoU asset and related lease liability.  So, as noted with the simple inclusion of operating leases on the balance sheet affecting debt covenants, electing this practical expedient could even further impact on financial metrics and existing debt covenants.  Assuming lenders do not include this new liability when they calculate ratios referred to in loan covenants, there should be minimal impact to existing loan covenants.  However, companies should discuss with lenders to ensure that they understand the impact of changes on the statement of financial position to determine whether loan covenants should be renegotiated.  Additionally, investors and other stakeholders should be made aware of the impacts of the new standard.

As noted above, there are many implications to the new leasing standard in which companies must be made aware. Only two issues were discussed in this article.  Click here to see how Kaplan Professional Education is here to assist your company by educating your personnel on the many other issues to be considered within this new Standard, as well as providing guidance and practical application in a number of other accounting topics.

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