ASC 842 Lease Accounting

What is ASC 842?

ASC 842 is an accounting standard issued by the Financial Accounting Standards Board (FASB) that governs the accounting treatment for leases. It requires companies to recognize lease assets and liabilities on their balance sheets for almost all leases, including operating leases, previously only disclosed in footnotes.

ASC 842 Lease Accounting

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.

ASC 842 Summary of Changes

The lease accounting standard ASC 842, replaces the lease accounting standard ASC 840.

Why was ASC 840 replaced with ASC 842?

Given the high cost of leases and their historical lack of representation on the balance sheet, the introduction of ASC 842 provides transparency into organizations’ lease liabilities.

Before ASC 842, operating leases were not included on the balance sheet, which neglected to provide a full picture of cash flows from leases. This meant companies and investors were unable to identify how much debt was carried within a business’ lease obligations.

The new lease accounting standard requires organizations to include operating leases and financial leases on the balance sheet, which increases visibility into leasing costs and arrangements. This ensures an accurate depiction of company financials.

In addition, ASC 842 closely aligns 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.

Who Does ASC 842 affect?

ASC 842 affects private and public companies of all industries and sizes within the U.S., including construction, business services, healthcare, manufacturing, retail, hospitality, transportation and more.

ASC 842 Lease Accounting

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.

Lease Accounting Updates

Since FASB was issued ASC 842 in 2016, there have been numerous updates, such as:

•     ASU 2017-13: Amendments to SEC Paragraphs
•     ASU 2018-01: Land Easement Practical Expedient for Transition
•     ASU 2018-10: Codification Improvements
•     ASU 2018-11: Targeted Improvements
•     ASU 2018-20: Narrow-Scope Improvements for Lessors
•     ASU 2019-01: Codification Improvements
•     ASU 2019-10: Effective Dates
•     ASU 2020-02: Amendments to SEC Section on Effective Date
•     ASU 2020-05: Effective Dates for Certain Entities
•     ASU 2021-05: Lessors – Certain Leases with Variable Lease Agreements
•     ASU 2021-09: Discount Rate for Lessees That Are Not Public Business Entities

 

Lease Accounting Subtopics under ASC 842

ASC 842 Lessee accounting for finance and operating leases

Lessee accounting for finance and operating leases

Under the previous guidance, ASC 840, leases were labeled capital or operating leases. However, their labels were changed to finance and operating leases under ASC 842.

The criteria defining a finance lease is as noted under the guidance in 842-10-25-2:

•       The lease transfers ownership of the underlying asset to the lessee by the end of the lease term
•       The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise
•       The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease
•       The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset

If none of the criteria applies, then the lease would be considered an operating lease.

Accounting for both the finance lease and operating lease are similar under ASC 842, unlike ASC 840. The new standard now requires both leases to recognize both the lease liability and the right of use asset on the balance sheet unless the lease is considered a short-term lease (12 months or less).

Lessor accounting under ASC 842

Lessor accounting has not had any significant changes under ASC 842. Similar to ASC 840, lessors still need to determine the type of lease to record, which will be either an operating lease, sales type lease or a direct financing lease.

Under a sales type lease, the lessor is assumed to be selling a product to the lessee, which calls for the recognition of a profit or loss on the sale. For the lessor to classify the lease as a sales back lease, the lease must meet any of the criteria, noted within 842-10-25-2 (provided above) at lease commencement.

Further, when none of the criteria in 842-10-25-2 are met, a lessor shall classify the lease as either a direct financing lease or an operating lease as noted within 842-10-25-3. The following criteria within the standard are as such:

If both of the following criteria are met, the lessor should classify the lease as an operating lease:

•       The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) and/or any other third party unrelated to the lessor equals or exceeds substantially all of the fair value of the underlying asset.
•       It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee.

Otherwise, the lessor is to classify the lease as a direct financing lease.

ASC 842: Financial Statement & Calculation Impacts

Under ASC 842, almost all leases must be represented on the balance sheet with a liability and an 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.

How are lease calculations impacted under ASC 842? How can ASC 842 Compliance Software assist with these changes?

ASC 842 requires lease obligations to be captured on the balance sheet. The calculations that are involved to stay compliant are extremely susceptible to error – particularly if done without automation.

Lease accounting software assists with ASC 842 compliance by automating calculations and financial reports. It enables you to ensure reliable data – and provides transparency into the math behind the calculations.

Without automated calculations or processes around lease management, you may run into issues related to human error or lack the ability to back up your calculations.

ASC 842 Practical Expedients

Businesses can elect practical expedients to apply the accounting guidance more easily. Depending on the type of practical expedient, they can be elected by lease, class of asset or as an accounting policy. Examples of practical expedients include:

•       Initial direct costs for leases that commenced before the effective date
•       The ability to use hindsight in evaluating lessee options to extend or terminate a lease or to purchase the underlying asset
•       Locking in a lease classification
•       Combining lease and non-lease components
•       Failing to restate the prior year’s financials

ASC 842 Disclosure Requirements

The disclosure requirements for ASC 842 are quantitative and qualitative. Under ASC 842, a lessee must disclose information about the nature of its leases and lease terms and conditions. This includes general descriptions of leases and various details regarding terms and conditions, such as the basis that variable lease payments are determined.

 

ASC 842: additional reading

How does ASC 842 change the balance sheet?

Previously, only capital leases — 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.

This 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 an element of a contract that conveys 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 for 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.

Note: ASC 842 does not include assets that are covered in other accounting 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?

IFRS 16 includes 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.

 

How to calculate a lease liability 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 also 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

Over the life of the lease, the ROU is amortized linearly. All of the assets and liabilities that adjust the ROU asset are 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 had 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.

How to Transition to ASC 842

Preparing for ASC 842 is a time-consuming, comprehensive effort that expands further than the accounting and finance department. It requires cross-departmental collaboration between IT, legal, procurement, etc.

In fact, since the introduction of the new standard, impacted private companies have been slow to make the transition. In July 2021, The Visual Lease Data Institute (VLDI) reported 75% of surveyed private companies were not yet fully compliant with ASC 842. In addition, 40% said they were underconfident in their ability to comply with the new lease accounting standard because they didn’t have all the necessary lease data gathered.

As of August 2022, The VLDI reported that while nearly all private companies (98%) have started the transition to ASC 842, one-third (33%) are still not fully prepared to implement the new standard.

Businesses are under massive pressure as they attempt to prepare for their initial reporting period under the new lease accounting standard.

The steps and milestones to ensure a successful transition to the new accounting standard are:

•       Planning and analysis

o   Determine project stakeholders and project lead

o   Determine and approve budget for solution

o   Collect and prep leases across portfolio

o   Conduct needs assessment for a solution

•       Software evaluation

o   Kickoff software vendor evaluation

o   Attend solution demonstrations

o   Sign preferred vendor contract

•       Implementation

o   Gather business requirements and build timeline

o   Complete software configuration

o   Lease review, data analysis and entry

o   Validation and testing

o   Journal entry and disclosure pilot

•       Go-live and transition

o   Go live with software

o   User training

o   Adopt platform internally

o   Transition to new FASB accounting standard

•       Operationalizing and sustaining

o   Ongoing maintenance (remeasurements, data management, change management)

o   Annual reporting

Benefits of New Standards and Implementation

According to data from The VLDI, 71% of private companies believe ASC 842 presents an opportunity for their business.

The new lease accounting standards encourage organizations to adopt a centralized view of their lease portfolio, providing them with an opportunity to prioritize a proper lease management strategy. In turn, this provides them with much of the information they require to remain adaptable in a post-pandemic world.

Using a centralized system of record for leases provides companies with the ability to quickly and easily access crucial terms and clauses, such as the ability to exit, extend or change a lease.

With this newfound visibility, companies can respond to unforeseen circumstances strategically, such as a retailer needing to shutter brick-and-mortar locations or exercise an exclusivity or force majeure clause to protect the future of its business.

While some organizations manage and report on their leases using Excel, research has repeatedly shown that 90% of spreadsheets contain errors with 50% of processes enabled through those spreadsheets having “material defects”.