ASU Lease Topic 842 – What Is It and How Does It Impact Your Business?

Jason Hofferica

CPA, CVA | Manager

Implementing new accounting standards can often be a daunting task for businesses, requiring significant adjustments to their financial reporting processes. One such change came in February 2016, when the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02, “Leases (Topic 842)”. This update, effective for annual reporting periods beginning after December 15, 2021, marked a significant shift in how companies must account for leases. As businesses navigate these new requirements, understanding the nuances of ASU 2016-02 became crucial in ensuring compliance and accurate financial reporting.

In this ASU, lessees are required to recognize a right-of-use asset and associated lease liability on their balance sheet for most operating leases, with exemptions provided to those operating leases with an initial lease term of twelve months or less.

The reasoning behind this ASU is that when entities enter operating leases, they have a “right-of-use” asset and liability with this agreement that prior to this ASU, would have only needed to be disclosed in the footnotes to the financial statements in the form of future payments.

What this pronouncement requires is that the operating right of use assets and lease liabilities are recorded on the date of lease commencement based on the present value of the lease payments over the lease term. Further, over the course of agreement, both the asset and the liability are amortized, which is calculated based on the discount rate. The pronouncement allows for using the risk-free or incremental borrowing rate, depending on the entity’s policy election, that most closely aligns with the terms of the lease agreement at inception.

Think of it as the entity purchasing a tangible asset and financing by obtaining a loan, even though no such loan exists. Therefore, cash paid on the lease will no longer be solely categorized as a lease expense in accordance with Generally Accepted Accounting Principles, but rather a combination of the cash paid, periodic lease expense, and the amortization of the right-of-use asset and right-of-use-liability.

If the entity is subject to financial covenants with a financial institution, this pronouncement may affect the financial ratios to stay in compliance. It is important to discuss with the financial institution and to adjust any covenant calculations to remove its impact from these calculations.

The bad news is regarding the increased burden of implementing ASU 842, especially considering that the resulting change, usually is a marginal change to the entity’s bottom line as it mostly impacts the balance sheet. The good news is that we at Cray Kaiser,  understand the ASU and its calculations and can assist with consulting and calculations to navigate this new standard. You can contact us here or call us at (630) 953-4900.   

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