Most organizations would agree that effectively managing lease accounting can be challenging.
However, by thoroughly understanding the new ASC 842 guidelines, companies can smoothly transition to the updated reporting standards and realize long-term benefits.
In this comprehensive guide, we will demystify ASC 842 by breaking down key terminology, outlining critical changes, summarizing implementation steps, and addressing frequently asked questions. Additionally, through practical examples and clear explanations, you will gain the knowledge needed to accurately account for leases under the new FASB regulations.
Introduction to ASC 842 Lease Accounting Requirements
ASC 842 is a new accounting standard that fundamentally changes how companies account for leases. It introduces major changes around the recognition, measurement, presentation and disclosure of leasing activities.
What is ASC 842?
ASC 842, or Accounting Standards Codification 842, is a new accounting standard issued by the Financial Accounting Standards Board (FASB) that impacts lease accounting and reporting. The standard requires that lessees recognize right-of-use assets and lease liabilities on the balance sheet for most leases. This brings greater transparency around companies' financial leverage and capital employed.
ASC 842 Effective Date for Compliance
ASC 842 took effect on January 1, 2022 for public companies. For private companies and nonprofits, the effective date has been deferred to fiscal years beginning after December 15, 2021. Therefore, private companies must adopt ASC 842 by January 1, 2023 at the latest.
Scope of ASC 842: Applicability Across Organizations
The scope of ASC 842 applies to both lessees and lessors, requiring new lease accounting for operating leases. Public companies were required to adopt ASC 842 in 2022 and report under the new standard, while private companies have until 2023 to comply. All organizations entering new or amended lease agreements should ensure they understand the implications of ASC 842.
What is the ASC 842 standard for lease accounting?
The ASC 842 standard, also known as the new lease accounting standard, was issued by the Financial Accounting Standards Board (FASB) to improve transparency and comparability of lease obligations.
ASC 842 requires that lessees recognize assets and liabilities on the balance sheet for all leases with terms longer than 12 months. It also eliminates the classification of leases as either operating leases or finance leases for lessees. Instead, lessees must recognize a right-of-use asset and a lease liability for virtually all lease contracts.
Some key points about ASC 842 include:
- Applies to both public and private companies that follow US GAAP
- Went into effect in 2019 for public companies and in 2022 for private companies
- Requires capitalization of operating leases longer than 12 months
- Changes how lease expenses are recognized on income statement
- Expands disclosure requirements for additional details on leasing arrangements
By recognizing essentially all leases on the balance sheet, the new standard is intended to give investors and other financial statement users a more accurate picture of a company's leasing activities and obligations. While ASC 842 does not fundamentally change lessor accounting, there are some changes to align lessor accounting with the new lessee model and to address certain practice issues.
What are 3 of the criteria used to determine if a lease is accounted as a sales financing lease?
There are five key criteria that determine whether a lease should be classified as a sales-type lease (finance lease) or an operating lease under ASC 842 guidelines:
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Bargain purchase option: The lease agreement contains an option for the lessee to purchase the asset at a price which is sufficiently lower than the expected fair value at the date the option becomes exercisable.
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Transfer of ownership: The lease agreement contains terms and conditions that transfer ownership of the underlying asset to the lessee by the end of the lease term.
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Lease term: The lease term makes up a major part (75% or more) of the remaining economic life of the leased asset.
If a lease meets any one of these three criteria, it would need to be classified as a sales-type or finance lease under ASC 842. The criteria focus on situations where the lease is effectively providing the lessee with ownership rights to the asset.
What are the criteria for lease accounting?
There are a few key criteria that determine whether a lease should be classified as a capital/finance lease or an operating lease for accounting purposes:
Capital/Finance Lease Criteria
A lease is considered a capital or finance lease if it meets any one of the following criteria:
- Transfer of Ownership: The lease transfers ownership of the asset to the lessee by the end of the lease term
- Bargain Purchase Option: The lease contains a bargain purchase option that the lessee is reasonably certain to exercise
- Major Part of Economic Life: The lease term is for the major part of the remaining economic life of the underlying asset
- Present Value Test: The present value of the minimum lease payments equals or exceeds substantially all of the fair value of the leased asset
For example, if a 5-year equipment lease transfers ownership to the lessee after the lease ends, it would be classified as a capital lease.
Operating Lease Criteria
If a lease does not meet any of the preceding capital lease criteria, it is considered an operating lease. Operating leases are viewed more like rentals.
Some key features of operating leases:
- Leased asset is returned to lessor at end of lease term
- Lease term is shorter relative to economic life of asset
- Present value of payments is less than the asset's fair value
For instance, a 3-year office space lease would likely be an operating lease since ownership is not transferred, the term is short relative to the building's life, and regular rental payments are made.
Understanding these lease classification criteria is critical for properly accounting for leases under ASC 842 guidance. Misclassifying a lease could lead to errors and misrepresented financials.
What is the required disclosure for lessees under ASC 842?
ASC 842 requires lessees to provide more extensive disclosures than previous standards. These disclosures are intended to give financial statement users better insight into a company’s leasing activities.
Specifically, ASC 842 requires separate disclosure of:
- Operating lease expense: This represents lease payments related to leases classified as operating leases under ASC 842.
- Finance lease expense: This represents amortization of the right-of-use asset and interest expense related to leases classified as finance leases under ASC 842.
Additionally, companies that elect the practical expedient for short-term leases must disclose that election and the short-term lease expense amount recognized in the reporting period. The practical expedient allows companies to essentially account for short-term leases (terms of 12 months or less) similar to operating leases under the previous ASC 840 standard.
In summary, ASC 842 requires more robust disclosures around lease expenses and activity, splitting out operating versus finance leases. It also requires specific disclosure if a company uses the short-term lease practical expedient. The goal is to provide greater transparency into a company's leasing transactions.
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Key Changes Introduced by ASC 842
ASC 842 introduces major changes to lease accounting standards, with the goal of increasing transparency and comparability of lease obligations. By eliminating the operating vs capital lease classification and requiring lessees to recognize assets and liabilities for most leases, ASC 842 significantly impacts financial reporting.
Transitioning from Operating to ASC 842 Operating Lease Accounting
- ASC 842 eliminates the concept of operating vs capital leases. Now, lessees must put most leases on their balance sheet by recognizing a "right-of-use" asset and lease liability.
- Only short-term leases (less than 12 months) and low-value asset leases can remain off balance sheet. This differs from the old rules that allowed operating leases off balance sheet.
- For existing leases, companies can transition using either the modified retrospective approach or cumulative effect adjustment approach. The modified approach recasts prior years under ASC 842, while the cumulative approach records the impact on January 1, 2019.
New Lease Measurement and Disclosure Rules Under ASC 842
- Lessees must estimate the lease term, including renewal options that are reasonably certain to be exercised. This determines the number of payments used to calculate the lease liability.
- Lease liabilities are measured as the present value of future lease payments over the term. The right-of-use asset equals the lease liability in most cases.
- ASC 842 requires more extensive footnote disclosures regarding lease obligations, including qualitative and quantitative information on the amounts, timing, and uncertainty of cash flows.
Financial Statement Impact with ASC 842 Implementation
- With more leases on the balance sheet, companies appear more leveraged under ASC 842. Key financial ratios like debt/equity and EBITDA are impacted.
- On the income statement, a single lease expense replaces rent expense. This leads to higher expense in early years and lower expense in later years.
- Cash flow classifications change as well - operating cash flow increases under ASC 842, while financing cash flow decreases.
Implementing ASC 842 Lease Accounting for Private Companies
This section outlines key steps private companies should take to successfully transition to ASC 842 by 2023, including lease review, policy updates, system changes, and more.
Conducting a Thorough Lease Agreement Inventory
Private companies should take the following steps to inventory their leases:
- Assemble a cross-functional ASC 842 implementation team with representatives from accounting, finance, legal, IT, and real estate.
- Identify all arrangements that could contain a lease under ASC 842's expanded definition. This includes obvious agreements like real estate leases, as well as embedded leases often overlooked like copiers or coffee machines.
- Review each arrangement to determine if it meets ASC 842 criteria for a lease:
- There is an identified asset.
- The company obtains substantially all economic benefits from use of the asset.
- The company directs how and for what purpose the asset is used during the term.
- Extract key data like payments, terms, options, variable payments, etc. Input into a lease accounting software or spreadsheet.
Conducting a detailed lease review is crucial for private companies to understand the full impact of ASC 842 on their financial reporting. Identifying all leases early is key to accurate accounting and smooth adoption.
Updating Accounting Policies with ASC 842 Guidance
To transition to ASC 842, private companies should update their accounting policies and manuals with guidance tailored to their specific lease agreements and risk profile, including:
- Lease classification - Classify leases at commencement as operating or finance leases based on criteria focused on consumption of economic benefits.
- Lease measurement - Measure leases differently depending on classification. Finance leases recognize amortization and interest expense. Operating leases recognize a single lease cost allocated over the term.
- Balance sheet recognition - Recognize assets and liabilities for leases greater than 12 months. This significantly impacts financial ratios under ASC 842.
- Disclosures - Enhance disclosures including qualitative and quantitative information on leases, providing greater transparency into lease obligations.
Consult with external auditors to obtain recommendations on accounting policy updates to comply with ASC 842 transition guidance and align to the company's risk profile.
System Requirements and Reporting Integration for ASC 842
Most private companies will require new software to account for leases under ASC 842 due to increased data tracking and complex calculations required, including:
- Tracking detailed data like payments, terms, options, variable lease costs, etc. for each lease.
- Performing ASC 842 classification tests at lease commencement.
- Calculating finance lease assets and liabilities using effective interest method.
- Calculating operating lease ROU assets and liabilities.
- Handling ongoing journal entries over the lease term.
- Generating disclosures and visualizing lease data.
The lease software should integrate with the existing financial reporting system to transfer accounting entries and data to the GL, eliminating manual processes.
Selecting the right software and planning systems integration is key for accurate ongoing ASC 842 compliance.
Lessor Accounting Considerations Under ASC 842
While ASC 842 focuses mainly on lessees, it also impacts lessors. This section examines key accounting changes lessors face in areas like subleases, collectability, and more.
Allocating Payments Between Lease and Nonlease Components
Lessors must separate payments for lease and nonlease components and allocate them appropriately. For example:
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If a lessor provides equipment as well as maintenance services for the equipment, these would be considered separate lease and nonlease components.
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The total payments received must be allocated between the lease component and nonlease component based on stand-alone selling prices.
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This allocation can impact revenue recognition and balance sheet presentation for lessors.
Proper identification and separation of lease and nonlease components is an important lessor accounting consideration under ASC 842.
Evaluating Lease Collectability as per ASC 842 Lessor Accounting
ASC 842 requires lessors to assess collectability of lease payments from the lessee at lease commencement.
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If collection is not probable, lessors may not be able to recognize revenue.
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This determination requires judgment about the lessee's ability and intent to pay.
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Factors like credit history, liquidity, operational risks, etc. should be considered.
If collection risk is significant, lessors may need to adjust their accounting. Ongoing monitoring of collection probability is also required.
Understanding Sublease Accounting Changes with ASC 842
Under ASC 842, accounting for subleases depends on the classification of the original “head” lease, either before or after adoption of the standard.
For example:
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If the head lease is an operating lease, the sublease would typically also be classified as operating.
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However, if the head lease is a finance lease, the sublease could be classified as either operating or finance.
Lessors need to determine the appropriate classification and resulting accounting for any subleases under their head leases. This may represent a change from previous standards.
Careful analysis of lease agreements is required for compliance with ASC 842 sublease guidance.
Frequently Asked Questions About ASC 842
This section provides answers to some common questions private companies have around ASC 842 compliance, covering lease definition, transition, disclosures, and more.
Determining Lease Agreements In Scope of ASC 842
ASC 842 applies a broad definition of leases. Companies should carefully review agreements like outsourcing, supply chain, retail, transportation, etc. to determine if they meet the ASC 842 criteria for a lease:
- There is an identified asset in the contract that is explicitly or implicitly specified. This could be a building, piece of equipment, vehicle, etc.
- The customer has the right to obtain substantially all of the economic benefits from use of the asset throughout the period of use. For example, the customer has exclusive use of the asset during the lease term.
- The customer directs the use of the asset throughout the period of use. The contract specifies how and for what purpose the asset will be used during the lease term.
If an agreement meets all three criteria, it would qualify as a lease under ASC 842.
Required Lease Disclosures Under ASC 842
In financial statements, companies must disclose information about significant judgements, payments due, options, variables, cash flows, ROU assets, and more. Specifically, the disclosure requirements include:
- Judgements made in applying ASC 842, such as determining the discount rate
- Information about leases like description, terms, variable payments
- Maturity analysis of lease liabilities showing undiscounted cash flows
- Total operating lease ROU assets obtained in exchange for lease obligations
- Cash paid for amounts included in lease liabilities measurement
- Supplemental non-cash information on lease liabilities arising from ROU assets
- Weighted average discount rate and term for operating leases
Early Adoption Considerations for ASC 842
Private companies cannot early adopt ASC 842, they must begin comply no later than accounting periods beginning on or after December 15, 2021.
Some key dates in the ASC 842 transition timeline for private companies:
- January 1, 2021: Early adoption allowed
- December 15, 2021: Mandatory adoption date
- Calendar 2022: First ASC 842 compliant financial statements
When transitioning, private companies will need to provide comparative reporting periods, with a cumulative catch-up adjustment to opening retained earnings in the earliest period presented.
Conclusion and Key Takeaways on ASC 842 Lease Accounting
ASC 842 significantly changes lease accounting and reporting for private companies, who face a 2023 deadline. Key steps for adoption include reviewing agreements, updating policies and systems, and enhancing processes for lease data collection and disclosure.
Understanding the Significance of ASC 842
ASC 842 improves financial reporting for leases by requiring companies to recognize right-of-use assets and lease liabilities on the balance sheet. This enhances transparency around a company's financial leverage and assets under operating leases.
The new standard also improves comparability between companies that lease assets and those that purchase assets. Companies are now required to provide enhanced disclosures around their leasing activities.
Overall, ASC 842 enables stakeholders to better understand a company's leasing activities and make more informed decisions.
Critical Preparation for the ASC 842 2023 Deadline
Private companies have a 2023 deadline to adopt ASC 842. To prepare, key steps include:
- Reviewing all lease agreements to determine impact
- Assessing current lease accounting processes and systems
- Implementing new software to track leases
- Engaging CPAs to provide guidance on transition
Without proper preparation, the 2023 effective date will significantly strain resources. Companies should start planning now by assembling a cross-functional ASC 842 adoption team.
Long-term Impacts on Lease Accounting and Financial Statements
For companies with large lease portfolios, ASC 842 will fundamentally change financial statements well beyond 2023.
Balance sheets will reflect higher assets and liabilities. Income statements will show front-loaded expense recognition and classification changes. Statement of cash flow presentation will also be impacted.
Ongoing lease portfolio management and financial reporting processes will need to adapt. For some companies, debt covenants may even need renegotiation.
In summary, private companies should urgently prepare now for substantial ASC 842 changes spanning systems, processes, and personnel.
