In 2016, the FASB issued new lease accounting standards that changed how businesses reported leases on their financial statements. For most private entities and nonprofits, the new standard went into effect in 2022. As we are approaching the end of the second year of complying with the new lease accounting standard (Topic 842), these are some of the most common issues we get questions about.
Discount Rates
The new lease accounting standard requires nearly all leases with terms that exceed one year to be recorded on the balance sheet as “right of use” assets with corresponding lease liabilities for the present value of future lease payments. Unfortunately, the present value calculation isn’t always straightforward.
To determine the present value of future lease payments, you’ll need to apply a discount rate. According to Topic 842, your discount rate should be one of the following:
1. The rate implicit in your lease.In some cases, you can back into the rate that’s implicit in your lease, but only if you have the following information:
- Your lease payments
- The amount your lessor hopes to derive from the underlying assets at the end of the lease term
- The fair value of your asset (minus any related investment tax credit to be retained by the lessor)
- Any of the lessor’s deferred initial direct costs
Because many lessees aren’t privy to their lessor’s information, the implicit rate can be difficult to determine.
2. Your incremental borrowing rate.
If you can’t determine your lease’s implicit interest rate, you can use your entity’s incremental borrowing rate, which is the rate of interest you would have to pay to borrow money equivalent to your lease over a similar term.
3. The risk-free rate.
If you make the appropriate election, you can use the Treasury Department’s risk-free rate, which is the interest rate investors would earn from an investment that carries zero risk. Just be sure to use the risk-free rate from an investment period that’s comparable to your lease term.
Terminated and Modified Leases
Once a lease has been terminated, no part of it should remain on your balance sheet. If a portion of the right-of-use (ROU) asset or lease liability remains, you should record the difference as a gain or loss on your income statement.
In some cases, though, you may not have a full termination. For example, if you terminate the lease of one asset before the end of its lease term but immediately lease a similar asset from that same party, you likely have a lease modification, instead. Lease modifications are recorded differently from lease terminations.
This is one of the most complex areas of Topic 842 because it’s not always obvious when there is a partial termination and when there is a modification. Here are a few examples:
- There would be a partial termination if the lessor decreased the size of the leased space before the end of the lease term.
- There would be a lease modification if you leased additional space in the same building.
- There would be a partial termination if the lessee’s right to use one of the underlying assets was revoked before the end of the lease term.
- There would be a lease modification if you extended the lease by an additional year.
Remeasuring Leases
If you have a lease modification, you first need to determine if your existing lease should be remeasured, or if you should account for the changes as a separate agreement.
From an accounting perspective, accounting for the change as a separate lease is the simplest solution. But to account for the change as a separate lease, both the following must be true:
1. The lease gives you additional rights to use an asset (e.g., additional square footage), and
2. The additional amount you’ve agreed to pay is at that asset usage’s standalone price.
When you have a lease modification that you cannot account for as a separate lease, you’ll need to go through the more tedious process of remeasuring your lease. When you remeasure your lease, you must reallocate the remaining consideration over the remaining lease term and apply an updated discount rate if needed. Any adjustment will be made to the value of the ROU asset and corresponding lease liability.
A few common situations that would require a lessee to remeasure their leases would be:
- Lease is modified
- Contingency is resolved
- Change in assessment of the lease term
- Change in assessment of purchase options
- Change in residual value guarantee
Related Party Leases
A consolidated entity may have leases between two or more of the related parties. Because these ROU assets and lease liabilities get eliminated when the financial statements are consolidated, our clients often ask us if they need to go through the process of recording leases under Topic 842.
The answer is that yes; typically, each standalone entity should be following the new reporting standards. If not, the consolidated entity would need to report that there has been a departure from Generally Accepted Accounting Principles (GAAP).
Common Control Arrangements — Changes Coming in 2024
The lease accounting standard won’t change in 2024, but the FASB has amended certain provisions that might change how you calculate or report leases. Accounting Standards Update (ASU) 2023-01 addresses two issues that private entities have had when reporting common control lease arrangements.
Issue 1: Practical Expedient to Use Written Terms Rather than Legally Enforceable Terms
Related-party lease arrangements between entities that are under common control are typically considered leases for purposes of the new accounting standard. Accounting for those leases is based on legally enforceable terms and conditions that are explicit or implicit in the arrangement.
Private entities have argued that this requirement was administratively burdensome, for some of the following reasons:
- Lease arrangements often lack detail to place a dollar value on the arrangement.
- Lease arrangements often get changed without approval from both parties.
- It is costly to obtain legal counsel to determine which rights and obligations are legally enforceable.
ASU 2023-01 addresses these concerns.
Beginning in 2024, the FASB offers a practical expedient for private companies and nonprofit entities with common control arrangements. To make accounting for these arrangements less administratively burdensome, these entities are permitted to use the written terms and conditions of the arrangement without having to consider whether the terms and conditions are legally enforceable. If no written terms or conditions exist, they cannot elect the practical expedient.
Issue 2: Accounting for Leasehold Improvements
The new lease accounting standard generally requires lessees to amortize leasehold improvement over the shorter of (1) the lease term, or (2) the leasehold improvement’s useful life. Entities with common control arrangements took issue with this, saying that it went against the underlying economics of these arrangements. Unlike agreements between unrelated parties where leasehold improvements typically only benefit either the lessor or the lessee, leasehold improvements in common control arrangements often benefit both parties.
Beginning in 2024, private entities are permitted to amortize leasehold improvements over the improvements’ useful life to the control group, regardless of the lease term, assuming the lessee continues to control the use of the underlying asset.
Other Accounting Changes are On the Horizon
Although the lease accounting standard under Topic 842 is important, it is not the only accounting standard change you should be thinking about. There are other reporting requirement changes that could impact your business in 2024. If you’re unsure how to apply this or any other reporting standard, contact us so that we can ensure you're on the right track.
