Accounting Standards Update (ASU) 2020-05 issued in June 2020, provided a deferral for all reporting entities that had not adopted the provisions of ASC 842. Due to this deferral, many healthcare organizations will be adopting this standard for the year ending December 31, 2022. The adoption of this standard requires significant analysis, calculation, and disclosure. There are several hospitals and healthcare systems that have already adopted this standard. The following discussion highlights common challenges and practical advice to consider, as learned through working with clients who have already adopted the standard. Additionally, we have included information regarding what to expect from your auditor during the audit cycle.
What is ASC 842 Leases?
ASC 842 requires organizations to record a right of use asset and lease liability on the balance sheet. Generally, all leases (regardless of classification as either an operating or a financing lease) will now be recorded on the balance sheet. Under previous accounting guidance, only capital leases were recorded on the balance sheet, with operating leases being disclosed within the footnotes of the financial statements. Under ASC 842, this concept will change, and a calculation will need to be performed to determine the right of use asset and lease liability to be recorded in the financial statements.
What is In, and What is Out?
The task of taking inventory and understanding the terms of lease contracts can be daunting. Identifying the asset, understanding control and right of use features, identifying lease and non-lease components and determining classification as operating versus finance are all just step one! Keep in mind that leases may be hidden in contracts that you might not consider to be leases, such as service and IT contracts. Additionally, contracts may not be centrally maintained, so the inventory of leases may require communication with other departments. To ease the burden, it may be helpful to consider materiality threshold when scoping certain classes of assets in or out of adoption. For example, some organizations are taking the position that copiers are immaterial to the financial statements as a whole (considering quantitative factors such as total capital assets, long term debt and liabilities, and qualitative factors such as debt covenants) and therefore will not include them in adoption.
These are good discussions to have early in the process with your auditor.
Presentation and Accounting Considerations
The most common accounting matter early adopters are experiencing is tracking the lease expense within their general ledger and recording monthly journal entries. Because the accounting and expense recognition for operating and finance leases differs from an income statement perspective, we recommend that organizations track the lease expense, amortization, and interest separately for operating and finance leases on the general ledger. Consider how you will utilize your general ledger and the journal entries that will be required to account for this information efficiently. This will aid in disclosures and year-end reconciliation.
Accounting for leases is not straight forward and considerations need to be given for renewal options and if contracts have lease and non-lease components, and/or embedded leases, which can be challenging for healthcare organizations.
Related to lease renewal considerations, the lease accounting dictates the presumption that if a renewal option exists, the lease will be renewed and should be built into the lease term for calculation purposes. However, there are many factors an organization should consider when determining the accounting for renewal: economic factors, historical experience, the availability of alternatives, pricing incentives received, etc.
An embedded lease exists when an organization enters into an agreement, and in connection with that agreement, receives a specific asset that it controls over a period of time in exchange for consideration. Many healthcare organizations enter service or supply contracts that give the right to use specific assets during a contract term, such as a diagnostic machine along with the medical supplies necessary to use the machine. If a healthcare organization does not identify and record embedded leases, the balance sheet and income statement could become misstated and the disclosures will be incomplete. As part of implementation, healthcare organizations should review existing contracts to determine if there is a service component and a leased asset component, or if a contract provides an asset ‘for free’ (a potential embedded lease) as a critical first step. ASC 842 offers a practical expedient to allow organizations to bundle lease and non-lease components together for administrative ease. This will result in a higher liability, and is required to be disclosed, so it is important to understand the impact of using or declining the practical expedient.
ASC 842 specifically requires right of use assets and lease liabilities arising from operating versus finance leases to be presented separately on the balance sheet. Most organizations that have adopted the lease standard are presenting finance leases as a component of fixed assets and long-term debt, respectively, with operating leases shown as the right of use assets and lease obligations on their own line, or within other assets and other liabilities. Now is the time to give some thought as to how the organization will present these on the balance sheet.
There are many required footnote disclosures related to leases, including separate operating and finance lease disclosures, assumptions and judgments made and practical expedients taken. There are also a variety of required quantitative disclosures. The first step should be to proactively start a dialogue with your auditor to understand all of the required disclosures so that you can gather and provide the information as you work through documentation and calculations.
Your auditor will need to audit the adoption of the new standard and will ask you to provide documentation of management’s analysis and determination that (1) the contract meets the definition of the lease and (2) the classification of each lease contract (operating versus finance). The auditor will also want to gain an understanding of management’s process and determine if a complete population of potential lease contracts was considered.
As a principals-based accounting standard, implementation provides management with many. In addition, your auditor will need to understand and view documentation of significant judgements, estimates, assumptions, policy elections or practical expedients that were utilized. This includes understanding the discount rate chosen for each lease obligation.
Next, the auditor will review the calculations compared to the terms of the lease contract. The underlying detail should roll up to a reconciliation to the general ledger, including total income statement activity and balance sheet beginning and ending balances.
The process of adopting the new lease standard can require a significant amount of additional time and effort by the business office and is not a process you want to wait until year-end close to undertake. Be sure to start gathering information now, so you are prepared to adopt this for the 2022 calendar year. Please reach out to our team at Bonadio for assistance related to adoption of this complex new standard.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.