ASC 842, the new Lease Accounting Standard, affects how organizations account for leases in their financial statements. Implementation could alter lease documentation, accounting, and disclosure. The change seeks to add more transparency for users of companies’ financial statements. Specifically, to move operating lease obligations from disclosure footnotes onto the financial statements.

The new lease reporting is required for all financial statements ending after December 15, 2022. It is possible to wait until then to implement the standard, but the new reporting is effective as of the beginning of 2022.

Organizations should not wait to compile their lease data, which might be complex or voluminous. Starting now provides the time to gather the data and avoid additional year-end closing stress.

ASC 842 affects how organizations document their lease

The current standard reflects current year lease expenses in the income statement and discloses future lease payments. The new standard requires organizations to calculate and record the present value of future lease payments as a lease liability with an offsetting right-of-use lease asset. With this change, nearly all leases must be recorded on the balance sheet.

The new standard also modifies the definition of a lease as it pertains to applying this standard. Some traditional leases are carved out, such as leases on intangible assets and inventory. In addition, some contracts previously not considered leases may fall under this standard, such as hiring a service provider for a period that will require the use of specialized equipment.

What are the effects of the change?

By recording a lease liability and right of use lease asset, an organization’s tangible equity and net working capital ratios could be negatively affected compared to the previous standard.

Adding these assets and liabilities to the balance sheet could significantly affect specific financial ratios used for various reporting purposes. For example, if debt covenants are based on debt-to-equity ratios, a company’s ability to satisfy that covenant after implementing the new standard could be seriously compromised.

What You Can Do

Start now on compiling your lease data. Gather and discuss items such as lease terms, base and increasing lease rates, how likely are termination and renewal options to be exercised, tenant allowances and what discount rate to apply will all play an integral role in measuring the effect on the balance sheet in 2022 and beyond.

Reach out to your lender if your loans contain tangible equity or net working capital ratios as part of your agreement. Renegotiate the loan or modify the agreement to take the ASC 842 change into account with these ratio calculations.