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What is ASC 842 & What Do I Need to Know?

By August 26, 2021Lease Accounting

ASC 842 effective date

Effective date for public companiesFiscal years beginning after December 15, 2018
Effective date for private companiesFiscal years beginning after December 15, 2021

ASC 842 summary

The Financial Accounting Standards Board (FASB) published the lease accounting standard ASC 842, which replaces the lease accounting standard ASC 840.

The purpose of ASC 842 is to increase disclosure and visibility into the leasing obligations of both public and private organizations. Where previously most leases were not included on the balance sheet, the new ASC 842 lease accounting standard requires companies to report right-of-use (ROU) assets and liabilities for almost all leases.

These changes to financial statements make it easier for investors, vendors, government agencies, and business stakeholders to (1) see a company’s exposure to risk and true financial position, and (2) make comparisons between organizations.

In addition, ASC 842 aligns more closely with the new international lease accounting standard IFRS 16 , especially in the way a lease is defined. This makes financial reporting more consistent for organizations with both U.S. and international lease assets.

For more differences between the new standards, take a look at our IFRS & FASB Lease Accounting Changes page for a quick reference to all of the improvements.

ASC 842: financial statement impacts

Under ASC 842, almost all leases must be represented on the balance sheet with a liability and a ROU asset. ASC 840 capital leases and ASC 842 finance leases are substantially the same. Both are capitalized on the balance sheet, and the method for doing so is similar under both standards. Discover how the new ASC 842 standard impacts the balance sheet

ASC 842 Compliance Software

ASC 842: additional reading

 

How does ASC 842 change the balance sheet?

Previously, only capital leases — those leases that are essentially purchase agreements — needed to be recorded on the balance sheet. But under ASC 842, most leases except for short-term leases must also be included on the balance sheet.

In addition, FASB has changed the treatment of all leases to be intangible assets. This changes the terminology for capital leases, or leases that represent a purchase agreement. These leases are now called finance leases.

That means companies must report ROU assets and lease liabilities for operating leases as well as for finance (capital) leases under ASC 842. So now IT and office equipment, vehicles, construction equipment, and other leased assets must appear on the balance sheet along with real estate leases.

All the leases recorded under ASC 842 will now be part of the total reported assets and liabilities on an organization’s balance sheet — significantly changing the company’s financial statements.

What is considered a lease under ASC 842?

A lease is defined as a contract or element of a contract that convey the right of use (ROU) of a physically distinct identified asset for a specified period of time in exchange for payment.

The identified asset can be property, plant, equipment, or other tangible assets. The period of time can be described in terms of the amount of use of the identified asset, such as the number of production units a piece of equipment will be used to produce, rather than in terms of time per se.

However, ASC 842 does not include assets that are covered in other standards:

  • Intangible assets (ASC 350)
  • Minerals and biological assets including timber (ASC 930, 932)
  • Inventory (ASC 330)
  • Assets under construction (Covered under ASC 360)

How has lease classification changed under ASC 842?

Besides renaming capital leases “finance leases,” ASC 842 added a fifth lease classification question (“Is the asset so specialized that it is only useful to the lessee?”) to the test that determines whether a lease is a finance lease or an operating lease.

Essentially this question says that after the asset is returned to the lessor, if the asset will have no value to anyone else without a major overhaul by the lessor, then the lease would be classified as a finance lease.

In addition, ASC 842 removed the so-called bright lines for the lease classification test. Previously these percentages were used to indicate what constitutes a “major part” of economic life (75%) or “substantially all” of the fair market value (90%); now these percentages are considered guidelines and you can elect whatever percentage you choose to use.

  • Transfer of title test: By the end of the lease term, will ownership of the asset transfer from the lessor to the lessee?
  • Bargain purchase option test: Is there a purchase option in the lease that the lessee is reasonably certain to exercise?
  • Lease term test: Does the lease term encompass the major part of the remaining economic life of the underlying asset?
  • Present value test: Is the present value of lease payments plus RVG (residual value guaranteed by the lessee) greater than or equal to substantially all of the fair market value of the asset?
  • Alternative use test: Is the asset so specialized that it is only useful to the lessee?

What does a lease classification test tell you?

Although almost all leases must be capitalized on the balance sheet under ASC 842, it is still necessary to classify them as either a finance lease (previously capital) or an operating lease. That’s because finance leases and operating leases are measured differently.

The lease classification test determines whether a leased asset is essentially an alternative method of financing the purchase of an asset, or if the majority of the life and/or value of the underlying asset is controlled by the lessee; if so, it must be classified as a finance lease. Otherwise, the lease must be classified as an operating lease.

Is there a low-value lease threshold under ASC 842?

Under IFRS 16, there is a threshold under which leases can be considered “low value” and do not have to be capitalized on the balance sheet. However, FASB has not specified a low-value threshold for excluding leases from the balance sheet under ASC 842. If this is an issue for your organization, you can discuss it with your auditors to determine if you can use a materiality threshold.

What is lease liability and how is it calculated under ASC 842?

Lease liability represents the current value of minimum future lease payments. To calculate it, you need to make assumptions about:

  • The likely amounts owed under residual value guarantee
  • Whether you are reasonably certain to exercise lease renewal options, termination options, or purchase options

The discount rate to use for the calculation is either the rate implicit in the lease (if known) or your organization’s incremental borrowing rate (IBR). Privately-held firms have the option to use a risk-free rate.

Keep in mind that the assumptions you make about lease options at the beginning of the lease often change over time. If during the term of a lease you change your mind about whether you are likely to exercise any lease options, you will need to remeasure both your lease liability and your ROU asset.

How is ROU calculated under ASC 842?

The ROU asset is calculated as the lease liability, plus or minus these adjustments:

  • Plus initial direct costs and prepaid lease payments
  • Minus lessor incentives, accrued rent, and ASC 420 liability at transition date

The ROU is amortized linearly over the life of the lease. All of the assets and liabilities that adjust the ROU asset are now reclassed from the balance sheet and included as one number to show the total leased asset.

Why do embedded leases have a bigger impact under ASC 842?

Previously, because operating leases were not on the balance sheet, embedded leases little impact on the income statement since the expense was usually being straight-lined. But now that all leases must be capitalized on the balance sheet, you need to:

  • Examine all contracts to find any embedded leases within them
  • Separate the lease components (for use of assets) from non-lease components (payments for the service) within the contract

Identifying embedded leases and their components is a complex task that takes time, judgment, experience, and consistency. It is another area where you might want to enlist the help and guidance of an accounting advisor.

 

 

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