ASC 842 lease accounting is effective for calendar year-end entities for the 2022 fiscal year. The core concept of ASC 842 is the intention by the FASB to move previously off-balance-sheet operating leases to the balance sheet to better reflect the contractual liabilities owed under these arrangements.
Many venture-backed early-stage startup companies, or remote-enabled companies, have minimal or no operating leases, but this does not mean ASC 842 concepts and provisions do not need to be considered.
Four Common Misconceptions for Tech and Startup Companies
Misconception 1: No Year-End Leases Equals No Impact
The company doesn’t have any leases as of year-end, so there is no ASC 842 impact.
This is a misconception because ASC 842 is required to be adopted as of the beginning of the period presented. Any leases outstanding as of 1/1/22 for calendar year-end entities would need to be included in the analysis of adoption and calculation of adoption entries.
Misconception 2: No Operating Leases Means No Need to Worry
The company has no operating leases and never has, so there is no ASC 842 impact.
While the absence of traditional operating leases for office space or equipment results in no impact of adoption related to those types of leases, ASC 842 requires entities to evaluate whether there are embedded leases that were not considered under prior guidance. A lease is defined by the FASB Master Glossary as:
“A contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.”
Many companies that do not have office leases may still have embedded leases with service providers that may need to be accounted for. In many cases, agreements with cloud providers for designated servers or server space (data centers and colocations) qualify as embedded leases and require capitalization.
Misconception 3: Related-Party Leases are Like Any Other Lease
Related-party leases are evaluated the same way under ASC 842 as old lease accounting standards.
ASC 842 requires that leases entered into with parties related to the company that are under common control are required to be assessed based on the written contract terms, regardless of the intent of the terms.
A related-party lease whereby either party may terminate the contract for convenience with no significant penalty would not have commercial substance and would not be a lease under ASC 842 as the terms are not enforceable over the specified terms. This is a change from prior guidance whereby related-party leases were evaluated for their economic substance above the legally enforceable terms and conditions.
Misconception 4: Only the Balance Sheet is Affected
ASC 842 impacts the balance sheet only, and has no other significant effects after adoption.
Companies should be diligent in considering the impact of adoption to reporting to external parties, especially banks that require financial covenant compliance, and plan proactively to inform stakeholders of any anticipated impact. Impacts to accounting and disclosure of deferred taxes should also be considered.
Companies should also ensure policies and procedures are put into place to account for new leases and contracts, and any lease modifications as they occur.
Make sure to review all lease agreements, amendments, and related documents carefully and keep any changes in writing. Related-party leases should also be evaluated to ensure the contract terms in the executed lease properly reflect the intended use.
Implementing ASC 842
These are just some of the many nuances in applying ASC 842 completely and accurately to ensure GAAP compliance for technology and startup companies. If you have questions, contact our team to understand the impact on your company.