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ASC 842 is a new accounting standard set forth by the Financial Accounting Standards Board (FASB). It includes significant departures from its predecessor (ASC 840), applies to both lessees and lessors, and will have far-reaching impacts on many businesses. These impacts will include major changes to accounting practices and financial reporting, as well as increased scrutiny of contracts, service agreements, and all leases starting now and moving forward.
While public companies have already adopted ASC 842 and evolved their practices, a large percentage of non-public business entities lag. Below, we examine several key components of lease accounting as affected by ASC 842 and what business stakeholders need to know.
A Lease or Not a Lease?
Many leases are quite straightforward. Familiar lease agreements typically involve common business needs such as office space, copiers, vehicles, and related equipment. Items like these are obviously subject to the new ASC 842 standard. What’s not so obvious, however, is when leases are present within contracts or service agreements where the word lease may not even appear (i.e., embedded leases).
Embedded leases are leases present in broader contracts or service agreements where an asset may not be specifically identified, however the user has control over an asset’s use and economic benefits. Unfortunately, the answer as to whether an embedded lease is present is not always clear. Let’s look at some examples:
- A bank’s service agreement with a security company includes the installation of cameras at their branches.
- A healthtech company required to comply with HIPAA outsources cloud data storage. The service agreement includes a dedicated server to ensure information integrity and security.
- A restaurant chain is provided point-of-sale terminals as part of its service agreement with a payment processor which brings PCI compliance into play and could involve the use of dedicated hardware.
- A manufacturer pays to place its logo in a baseball stadium. This occurs on the padded outfield wall, but also custom-built standalone structures at various points.
A series of tests are required to determine if an embedded lease is present in these situations. The primary questions that are evaluated in these tests are:
- Asset Identification
- Does the contract or agreement directly or indirectly indicate an asset?
- Is the asset physically distinct?
- Does the lessor have no substantial right to substitution?
- Asset Control
- Does the lessee hold all economic value from the asset’s use?
- Can the lessee determine the use of the asset?
An answer of “Yes” to all of the questions above may indicate the presence of an embedded lease. In the HIPPA example, the supplier holds no right to replace the server because it stores confidential information, so an embedded lease may be present. In the stadium example, the standalone promotional structures are assets only used and deriving economic benefit for one client, indicating the potential presence of an embedded lease. The space on the outfield wall is most likely not an embedded lease as the wall has another function, to stop a baseball, so the advertiser in not gaining all economic benefit. What about renting space for an ATM – is there an embedded lease?
As you can see, determining a yes/no answer to these questions above isn’t always obvious. That’s why it’s crucial to have cross-functional representation in the evaluation process, including the stakeholders involved in the agreements (e.g., sales, customer service, IT), as well as the right accounting and finance expertise. ASC 842 criteria changes also include considering whether the lease term spans the major part of the asset’s economic life and whether the present value of the lease payments amounts to the fair value of the leased asset.
Ensuring You’re Covered and Updating Your Lease Accounting Practices
ASC 842 updates create a lot of exposure for businesses. Before, the new standard, embedded leases may have been recognized but did not receive any special accounting treatment. Now, these leases must be represented from both an asset and liability perspective on the balance sheet. The impact of this on debt covenants and other instruments that limit financial ratios will be quite significant for some companies.
Companies are finding the lease evaluation process to be more complicated than they expected, even with software solutions that are beginning to help with the accounting entry part of the equation. Getting on top of ASC 842 will require locating and evaluating all contracts and agreements against the criteria noted above, as well as developing recurring entries moving forward. ASC 842 became effective for private companies for fiscal years beginning after December 15, 2021. Calendar year companies should already be compliant. If you have not yet made the change to ASC 842, the time to do it is now.
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