Our lease accounting series includes a comprehensive breakdown of implementation considerations, including:
- Lease tracking solution (Excel vs. lease software)
- Resources needed to implement and maintain
- Identifying the lease portfolio
- Evaluating the lease agreements and overall scope
- Calculating the lease obligations and right of use assets
- Financial reporting and disclosures
- Internal control processes going forward
In this article, we continue the lease accounting series by evaluating the impacts of financial reporting and disclosures associated with the adoption and implementation of ASC 842, including potential changes to covenant compliance with your lenders. Additionally, we discuss common changes to internal control processes resulting from ASC 842 implementation as well as internal control considerations to be made on a “go-forward” basis.
Financial Reporting and Disclosure
The impact of ASC 842 adoption will be felt by nearly every company’s financial reporting team due to its sizable impact on reporting metrics. Common Generally Accepted Accounting Principles (GAAP) financial reporting updates associated with the adoption of ASC 842 are as follows:
- The presentation of operating leases on the balance sheet versus an off balance sheet transaction. Each operating lease longer than 12 months will be recorded on the balance sheet as a right-of-use (ROU) asset with a corresponding lease liability. Calculation of the lease obligations and ROU assets were discussed in a previous article which can be found here.
- Under the modified retrospective adoption method, any equity adjustments associated with the recording of operating leases on the balance sheet will be recorded as a “cumulative effect” adjustment on the date of implementation (generally January 1, 2022 for private calendar year-end entities unless early adopted).
- Additional disclosure requirements and/or changes to existing requirements:
- Breakout of total rent expense by category, including finance lease cost, operating lease cost, variable rent, short-term lease cost, etc.
- Supplemental cash flow and non-cash information
- Weighted average remaining lease term for both finance and operating leases
- Weighted average discount rate utilized in the calculation for both finance and operating leases
- Future minimum rental payments for both finance and operating leases including amounts for interest
- Additional qualitative disclosures associated with the lease portfolio (practical expedients adopted, significant judgments made, the impact of adoption in year 1, etc.)
Given the significant financial reporting impacts associated with ASC 842 adoption, appropriate communication should be taking place with your lender(s) to ensure compliance with any covenant requirements. Financial ratios will most likely be affected when ASC 842 is adopted and we recommend that you work ahead with your lender(s) to determine appropriate updates to current covenant requirements which could include adjustment to required thresholds or GAAP exceptions for ASC 842 within the covenant calculations. Changes to a few common covenant requirements as a result of ASC 842 adoption are included below:
- Current ratio
- The current ratio will decrease upon adoption given the addition of current lease liabilities to the ratio denominator with consistent current asset totals. This ratio is not commonly used for restaurant companies.
- Funded debt to EBITDA
- Lenders are more often than not already including an adjustment for rent times 6 to 10 in any funded debt to EBITDA or lease-adjusted leverage ratio calculations which would minimize the impact of any additional funded debt from the adoption of ASC 842. However, as mentioned above, the proper precautions and discussions should be made with your lender to ensure the impact on your organization is minimal.
- Debt service coverage ratio
- Without the modification of definitions in lending arrangements, the debt service coverage may decrease as a result of the increase in total debt due to the recognition of operating lease liabilities. However, your lender may already include an adjustment for rent as annual rent times 6 to 10; so the impact may not be as significant. It is certainly worth discussing with your lender so the impact is minimal.
Internal Control Processes Going Forward
The changes in financial reporting presentation will result in necessary updates to internal control process design to ensure the appropriate capture of pertinent data and data integrity. Below are a few process updates we are commonly seeing as it relates to the changes associated with ASC 842, however, this list is not all-inclusive and will need to be tailored to your organization’s complexity and lease situation.
- Recording at year-end versus each period
- Financial reporting under ASC 842 will be required at least annually for GAAP financial statements and also to meet the requirements of lenders and other users of the financial statements, as applicable. Each organization will need to assess the cost and benefits of the frequency with which any applicable financial reporting entries should be made. If you have quarterly financial reporting requirements with your bank, then you will need to adjust at least quarterly to properly report GAAP results.
- Review process
- Given the significant reporting changes associated with ASC 842, additional management review controls will need to be performed to ensure appropriate monitoring and detective controls over reporting as well as the completeness and accuracy of underlying data. As lease terms change, a remeasurement of the right of use asset and lease obligation may be needed so having the proper controls in place to capture these changes will be necessary.
- System user access rights
- Many companies will need to utilize third-party software functionality to accurately track their lease portfolio, including journal entries and information for financial statement disclosure, given the associated complexities with implementation and ongoing accounting. Appropriate logical access and monitoring controls should be performed to ensure the security of the underlying data and segregation of duties are in place.
- Collaboration with lease negotiation team and other applicable operational personnel
- In order for financial statements to be materially accurate, a complete lease portfolio will need to be obtained to ensure that the opening ROU assets and corresponding lease liability are appropriately presented at the implementation date. Additionally, regular correspondence will need to be had between individuals negotiating leases and the financial reporting team to obtain up-to-date information on new leases, renewals, amendments, etc. that will impact financial reporting.
As this is the final article in our series on ASC 842 Leases, we have provided a roadmap on implementation and the many considerations you will need to evaluate. It is our advice to start early and not wait until the end of 2022 to implement. Ideally, you should be ready to go on the first day of your fiscal year 2022.
Who is empowering your growth? If you would like to talk through your approach, your GBQ team is here to help.
Article written by:
Tobin Perrill, CPA
Senior Manager, Assurance & Business Advisory Services