Planning An IPO? What You Need To Know About This Important New Accounting Rule

By Dantong Wang

ASC 842, the new lease accounting standard, is one of the most significant changes to financial accounting standards in recent memory, with pervasive accounting impacts that will substantially alter balance sheets for virtually all businesses.

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While the standard impacts all public and private businesses, companies that are contemplating an initial public offering or going public through a SPAC have additional planning considerations as they move toward adoption.

What is ASC 842?

Under ASC 842, leases with contractual terms of more than one year are required to be presented on the balance sheet. This means lessees are required to include lease obligation as a liability and the right-of-use as an asset, on their financial statement, regardless of whether it is an operating or financing lease.

Presenting all leases on a company’s balance sheet is a significant difference from ASC 840, the old lease standard, where operating leases were considered as off-balance sheet arrangement with disclosure only.

ASC 842 implementation deadline

After being delayed twice, ASC 842 is now effective for private companies for annual reporting periods beginning after Dec. 15, 2021. Calendar year-end companies are required to adopt the standard on Jan. 1, 2022.

Compliance considerations

Identifying leases: The first step in adoption is to identify the population of contracts that are impacted by the standard. Collecting this complete lease population is more time-consuming than one would expect. Under the new standard, businesses not only have to consider traditional lease agreements, but also any “embedded leases” that could be included in any contracts not labeled as a “lease contract.” For example, typical service contracts may include equipment that is conveyed to the contracting party, rendering the need for an analysis to determine whether it contains a lease under the standard.

Lease data management and reporting: The new lease standard requires a lot more data inputs than the previous model. Even the most basic terms may require additional considerations. The prescribed lease term is not always the contractual term since optional extensions and termination dates within control of the lessee must be considered.

Further, monthly lease payments must be analyzed for inclusion or exclusion in the asset and liability balances, and companies should gather information on fair value of leases, as well as non-lease and variable lease components. In addition, the new standard significantly increases the disclosure requirement, which mandates companies to collect and report more quantitative and qualitative data surrounding their lease transactions.

Sustainable and reliable internal process: Even after successfully implementing the new lease standard, companies are required to create a new internal process to ensure ongoing compliance. Companies generally benefit from having processes for capturing all new leases and amendments; identifying embedded leases; identifying unusual complex transactions, such as sales-lease backs; and other technical considerations to ensure timely and accurate financial reporting.

SPAC planning and ASC 842

Large companies that do not qualify as an Emerging Growth Company (EGC) are required to have adopted ASC 842 as of Jan. 1, 2019. This means that companies pursuing SPACs and expect to have $700 million or more in public equity float would have to go back and adjust their 2019 and 2020 financial statements if they have not already adopted the standard.

Furthermore, public companies are not provided the same shortcuts as private companies in determining incremental borrowing rates (IBR). The IBR is the rate at which the lease payments are present-valued to determine the liability obligation and right-of-use asset for purposes of grossing up the balance sheet.

Most companies will require outside assistance from a valuation expert in deriving their IBRs, which can differ for each lease and involve significant inputs and assumptions for modeling purposes. This process is further complicated if an entity has international operations in different economic environments where an IBR may differ from domestic subsidiaries.

Dantong Wang is a manager at BPM, a Top 50 accounting and advisory firm, where she helps guide clients through complex transactions, implementing new accounting standards, and converting between U.S. GAAP and IFRS accounting standards, among other services.

Illustration: Li-Anne Dias