New Accounting Rules For An Old Challenge
In 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02, Leases. This new lease accounting standard (ASC 842) significantly impacts how businesses across all industry sectors manage, account for, and report substantially all leases, including equipment and real estate.
Because of the meaningful accounting changes involved, public business began preparing to comply with the new standards several years ago. Privately held companies though, including most cannabis companies, received a pass until recently. And keep in mind that in order to legally mitigate the negative impacts of IRC Section 280E, a cannabis company must apply GAAP-based accounting to all of their books including those prepared for your tax returns.
So now that the new lease accounting standard is applicable for all companies, here’s what you need to know so that you can get it right for your cannabis business.
What Is The New Lease Accounting Standard?
ASC 842 requires organizations who lease assets— referred to as “lessees”—to recognize, on their balance sheet, the assets and liabilities for the rights and obligations created by those leases with terms greater than one year.
Why the change?
Under the previous lease standard, payment obligations of “operating” leases were not reflected on the balance sheet even if you have committed to many years of payments. In other words, there is a future debt (a liability) that is nearly invisible on financial statements.
Those payments are mentioned in the footnotes, but not prominently among other liabilities on the balance sheet.
Many organizations have dozens, or even hundreds, of operating leases, which can result in a huge gap for anyone trying to understand that company’s financial situation via their balance sheets. This is why the FASB made the change.
What Qualifies as a Lease Under ASC 842?
Because this is a judgment-based standard, judgment is often required to determine whether a contract qualifies as a lease under the new rules, but the following guidelines can help determine what qualifies as a lease:
- It must be a physical asset.
- You must have the right to control or use the asset.
- The asset must be explicitly or implicitly identified.
Examples of leases include (but are not exclusive to) rental of office space, photocopiers, computers and servers, vehicles, land, and equipment.
Examples of what are not typically considered leases include software subscriptions, leases for intangible assets, leases for exploration or use of non-renewable resources, and leases of inventory or assets under construction.
It’s also important to note that not all costs related to a lease are included in the leased asset and liability, so part of determining exactly what is a lease will be separating lease and non-lease components.
There is no hard and fast rule, as the new lease standard requires quite a bit of judgment. But the key is thinking about the intent of a particular payment. Common items that are likely to be non-lease components include common area maintenance and service contracts for the leased asset.
When reviewing lease contracts, it’s also important to determine if there are multiple lease components. If so, determine whether those components need to be tracked as separate leases on your books because they are designed to function separately. Conversely, they may have significantly different economic lives to evaluate.
► Pro Tip: Don’t forget to take advantage of the portfolio exception, where separate assets have similar terms and characteristics, and can be combined into a single lease for reporting purposes.
When Is The New Lease Accounting Standard Effective?
For public entities, the new lease accounting standard went into effect for the annual period beginning after December 15, 2018, and the calendar year 2019.
In June 2020, the Financial Standards Board (FASB) voted to delay ASC 842 for privately held companies due to the COVID-19 pandemic. With the deferral, private companies are now required to adopt for annual financial reporting periods beginning after December 15, 2021, which is 2022 for calendar year-end companies.
What Should You Do Now To Prepare?
Most companies should undergo a four-step process to prepare to implement the new lease accounting standard:
- Prepare a complete listing of all leases;
- Determine software needs to accumulating data and calculated required disclosures;
- Define implementation strategies; and
- Educate key stakeholders, including lenders and investors, on the changes.
Want to learn more? Speak with us about how we can help you prepare for the implementation of the new lease accounting standard so that you can keep your cannabis businesses compliant.
