Background
In February 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02, Leases (Topic 842), which applies to both lessees and lessors and results in significant changes to an entity’s balance sheet.
How Does Topic 842 Change Accounting for Leases?
Topic 842 replaces the extant lease accounting standard in Topic 840, Leases. Topic 842 creates a right-of-use model, which represents a change from Topic 840’s risk-and-reward approach. Under the new control-based approach, a lessee will recognize a right-of-use asset and corresponding lease liability on the balance sheet for all leases with lease terms that exceed 12 months. The right-of-use asset represents the lessee’s right to use the lease asset (real estate, equipment, etc.) over the term of the lease and will, generally, be reported as a non-current asset on the balance sheet. The lease liability represents the present value of the future lease payments and will, generally, consist of current and long-term liabilities on the balance sheet. Under the extant standard, lease costs were expensed as incurred for operating leases and future payments were only required to be disclosed in the notes to the financial statements.
Under Topic 842, all leases with terms in excess of 12 months will be reflected as an asset and corresponding liability on the balance sheet regardless of whether the lease is categorized as an operating lease or a finance lease. A finance lease is analogous to a capital lease under Topic 840. Under the new standard, operating and financing leases are treated the same on the balance sheet but slightly differently on the statements of income and cash flows.
When is Topic 842 Effective?
The effective date of Topic 842 depends on what type of entity is involved. In June 2020, as a result of the COVID-19 pandemic, FASB delayed the effective date for certain entities that had not yet adopted Topic 842.
The following table shows the effective dates by entity type:
| Type of Entity | Effective Date |
| Public Business Entities, Certain Not-for-Profit Entities, and Employee Benefit Plans That File With the SEC |
Fiscal years beginning after |
| Public Not-for-Profit Entities That Had Not Issued Their Financial Statements by June 2020 |
Fiscal years beginning after |
| Private Companies |
Fiscal years beginning after |
An entity may elect to early adopt Topic 842.
Are All Entities Required to Adopt Topic 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 reporting framework (i.e., cash basis, income tax basis or financial reporting framework for small- and medium-sized entities) are not required to adopt Topic 842.
Is There Anything My Company Should Consider About Adopting Topic 842?
Because Topic 842 requires operating leases to be carried on the face of the balance sheet, it is possible that this change will stress a company’s financial covenants with their lender (i.e., bank, financial institution or factor). It is important that companies determine the effect of Topic 842 on their financial statements and covenants early and discuss any issues with their banker as soon as practicable. If covenants need to be reset because of the effects of the adoption of Topic 842, it is better to have that discussion with the lender before a covenant violation has occurred rather than after.
If you have questions, please contact Victoria Pitkin or your ORBA advisor at 312.670.7444.
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