When Is ASC 842 Effective for Private Companies?

Accounting Standards Codification (ASC) 842 represents a significant shift in lease accounting standards. Issued by the Financial Accounting Standards Board (FASB), this standard enhances transparency and comparability in financial reporting. It mandates that organizations recognize most leases on their balance sheets by recording right-of-use (ROU) assets and corresponding lease liabilities. Previously, many lease obligations, especially operating leases, were not directly reflected on the balance sheet, appearing only in footnotes. This off-balance-sheet treatment could obscure a company’s true financial leverage. The new standard aims to provide a clearer and more comprehensive picture of a company’s financial position to investors and other stakeholders.

Understanding the Effective Date for Private Companies

The journey to ASC 842 compliance involved distinct timelines for public and private companies. Publicly traded companies adopted the standard for fiscal years beginning after December 15, 2018. The original effective date for private companies was set for reporting periods beginning after December 15, 2019. However, the FASB recognized implementation complexities for non-public entities.

The FASB issued Accounting Standards Update (ASU) 2019-10 in late 2019, deferring the effective date for private companies to fiscal years beginning after December 15, 2020. A second deferral occurred in June 2020, through ASU 2020-05.

ASU 2020-05 further postponed the effective date for private companies and private not-for-profit organizations to fiscal years beginning after December 15, 2021. For a private company with a calendar year-end, ASC 842 became effective on January 1, 2022. The FASB decided against any further deferrals for private entities.

Applying the Effective Date to Financial Statements

The effective date dictates when a private company must begin applying ASC 842 to its financial statements. For example, a company with a December 31st fiscal year-end applied the standard to financial statements for the year ended December 31, 2022. All leases existing at the beginning of that fiscal year must be accounted for under the new standard.

Companies transition to ASC 842 using a modified retrospective approach, which offers two primary options. One option allows companies to apply the new standard as of the effective date, recognizing a cumulative-effect adjustment to the opening balance of retained earnings in the adoption period. This means prior year financial statements would continue to reflect leases under the old ASC 840 guidance.

Alternatively, companies can apply the new standard as of the earliest comparative period presented in their financial statements. This method requires restating any comparative periods to conform to ASC 842, providing a fully comparable view. The choice between these transition methods impacts the presentation of historical financial data and should align with the company’s reporting objectives.

Preparing for ASC 842 Adoption

Identifying Leases

Preparing for ASC 842 adoption involves several steps. A primary task is the comprehensive identification of all contracts that contain a lease component, including those not explicitly labeled as leases. These “embedded leases” are agreements within a broader service or supply contract that convey the right to control the use of an identified asset for a period in exchange for consideration. For instance, a manufacturing services contract might include the dedicated use of specific machinery, constituting an embedded lease. Companies often involve various departments, such as procurement, legal, and operations, to review contracts and uncover such arrangements.

Data Collection

Once identified, detailed data points for each lease must be systematically gathered. This includes information such as the lease term, all lease payments (fixed, variable, and optional), the discount rate, and any renewal or purchase options. Accurate data collection is fundamental for correctly calculating the ROU asset and lease liability. Errors in this data can lead to inaccuracies in financial reporting and compliance issues.

Practical Expedients

ASC 842 provides several practical expedients to simplify the adoption process. Companies can elect a “package of practical expedients” which allows them not to reassess:
Whether existing or expired contracts contain a lease.
Lease classification from the old standard.
Initial direct costs for existing leases.

Other common expedients include:
Lessees can expense lease payments for short-term leases (12 months or less with no purchase option reasonably certain to be exercised), bypassing balance sheet recognition.
Private companies can use a risk-free rate as the discount rate, simplifying calculations compared to determining an incremental borrowing rate.
A practical expedient permits combining lease and non-lease components, streamlining accounting for contracts that bundle services with asset use.

System and Process Changes

The adoption of ASC 842 often necessitates changes to a company’s accounting systems, internal controls, and processes. Existing systems may not be equipped to capture the detailed lease data or perform the complex calculations for ROU assets and lease liabilities. Companies might need to implement specialized lease accounting software or enhance current enterprise resource planning (ERP) systems for ongoing compliance and accurate reporting. Robust internal controls must also be established to ensure the proper identification, measurement, and accounting for all lease agreements.

Financial Statement Impact

Companies should assess the potential impact of ASC 842 on their financial statements, key financial ratios, and debt covenants. The recognition of ROU assets and lease liabilities can significantly increase both total assets and total liabilities on the balance sheet. This balance sheet expansion can alter leverage ratios, such as the debt-to-equity ratio and debt-to-asset ratio, potentially affecting a company’s perceived financial risk. Liquidity ratios, like the current ratio, might also be impacted if the current portion of lease liabilities increases disproportionately to current assets. Companies should proactively communicate with lenders to discuss the implications for existing debt covenants, as the changes could technically trigger breaches even if the underlying economic activity has not changed.