Topic 842 Renters Basics – Real Estate and Construction

United States: Topic 842 Basics for tenants

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CONTEXT

In February 2016, the Financial Accounting Standards Board (FASB) released Accounting Standards Update (ASU) 2016-02, Leases (Topic 842), which applies to both lessees and lessors and results in significant changes in an entity’s balance sheet.

HOW DOES SUBJECT 842 CHANGE LEASE ACCOUNTING?

Subject 842 replaces the existing rental accounting standard in subject 840, Leases. Subject 842 creates a right-of-use model, which represents a change from the risk-reward approach of subject 840. Under the new control-based approach, a lessee will account for a right of use and a rental liability corresponding to the balance sheet for all rental contracts with a term of more than 12 months. The right of use asset represents the lessee’s right to use the leased asset (real estate, equipment, etc.) during the term of the lease and will generally be presented as a non-current asset on the balance sheet. Lease liabilities represent the present value of future lease payments and will generally consist of current and long-term liabilities shown on the balance sheet. Under the current standard, rental costs were expensed as incurred for operating leases and future payments were only to be disclosed in the notes to the financial statements.

Under theme 842, all leases with a term of more than 12 months will be reflected as an asset and a corresponding liability on the balance sheet, whether the lease is classified as an operating lease or a finance lease. A finance lease is analogous to a capital lease under theme 840. Under the new standard, operating leases and finance leases are treated the same on the balance sheet but slightly differently. in the statements of operations and cash flows.

WHEN IS SUBJECT 842 EFFECTIVE?

The effective date of topic 842 depends on the type of entity involved. In June 2020, due to the COVID-19 pandemic, the FASB delayed the date of entry into force for some entities that had not yet adopted Topic 842.

The following table shows the effective dates by type of entity:

Entity type Effective date
Public business entities, certain not-for-profit entities, and employee benefit plans filed with the SEC

Exercises starting after
December 15, 2018 (Calendar 2019)

Public not-for-profit entities that had not published their financial statements as of June 2020

Exercises starting after
December 15, 2019 (Calendar 2020)

Private companies

Exercises starting after
December 15, 2021 (Calendar 2022)

An entity may choose to early adopt subject 842.

ARE ALL ENTITIES REQUIRED TO ADOPT SUBJECT 842?

No. Only entities that prepare their financial statements in accordance with accounting principles generally accepted in the United States of America (US GAAP) are required to adopt Topic 842. Entities that present their financial statements in accordance with a special purpose accounting framework (that is to say, cash basis, income tax basis or financial reporting framework for small and medium-sized entities) are not required to adopt topic 842.

IS THERE SOMETHING MY BUSINESS SHOULD CONSIDER ABOUT ADOPTING SUBJECT 842?

Since Subject 842 requires operating leases to be recorded on the balance sheet, it is possible that this change will focus on a company’s financial commitments with its lender (that is to say, bank, financial institution or factor). It is important that companies quickly determine the effect of topic 842 on their financial statements and covenants and discuss any issues with their banker as soon as possible. If covenants need to be reset due to the effects of adopting Topic 842, it is better to have this discussion with the lender before a breach of the term occurs rather than after.

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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