Lease Accounting Guide: An Overview of ASC 842
What is ASC 842?
Accounting Standards Codification (ASC 842), Leases, is the new lease accounting standard issued by the Financial Accounting Standards Board (FASB). This new standard supersedes ASC 840.
ASC 842 contains guidance on the accounting and financial reporting for agreements meeting the standard’s definition of a lease. The new standard:
- Simplifies the accounting for leases under US GAAP
- Improve transparency of liabilities
- Disclose off-balance-sheet activities
What is a lease?
ASC 842 defines leases as contracts, granting “control” of an identifiable asset for a specific period in exchange for payment. To demonstrate “control” of an asset, a business entity must be able to obtain “substantially all” of the economic benefit from the asset’s use and direct its use throughout the period of the contract.
The history of ASC 842
In 2016, the FASB issued Accounting Standards Update (ASU) 2016-02. This update provided the new guidance for lease accounting through the creation of ASC 842. Topic 842 would be updated several more times, but ASU 2016-02 provided accountants with their first look at the new guidance on leases applicable to both public and private companies in the coming years.
Summary of changes:
Under ASC 840, only a limited number of leases were recorded on the balance sheet. An operating lease, for instance, was always an off-balance-sheet transaction. However, the payment obligations for an should be clearly presented so users of financial statements can assess the amount, timing, and uncertainty of cash flows arising from leases.
Given the widespread prevalence of off-balance-sheet leasing activities, the new lease accounting rules are intended to improve financial reporting and increase transparency. This new guidance will also require organizations to disclose information about leasing arrangements to the readers of the financial statements.
Implementing the new guidance will also provide management better insight into the true extent of their lease obligations and lead to improvements in capital allocation, capital budgeting, and lease vs. buy decisions.
ASC 842 effective date
For public companies, ASC 842 was effective for reporting periods that began after December 15, 2018. For calendar year-end companies, this means the standard was adopted on January 1, 2019.
For private companies and nonprofit organizations, ASC 842 is effective for annual reporting periods beginning after December 15, 2021.
Scope of ASC 842: What’s covered and what’s not covered?
ASC 842 applies to most leases and subleases, but exceptions do exist. There are some cases in which a contract contains a lease, but it’s out of the scope of Topic 842 and the guidance should not be applied to the transaction. Here are the out-of-scope lease types:
- Leases of intangible assets, such as cloud computing arrangements. The guidance for these agreements can be found in ASC 350, Intangibles – Goodwill and Other.
- Leases for the exploration or use of non-regenerative natural resources such as oil, natural gas, and minerals are covered under ASC 930, Extractive Activities – Mining, and ASC 932, Extractive Activities – Oil and Gas.
- Leases of biological assets such as plants, animals, and timber. These are addressed in ASC 905, Agriculture.
- Leases of inventory, which are covered under ASC 330, Inventory.
- Leases of assets that are under construction. These are addressed in ASC 360, Property, Plant, and Equipment.
Lease types in scope, under ASC 842:
- Lessee accounting for operating leases and finance leases
- Lessor accounting
- Sale-leaseback transactions
- Leveraged lease arrangements
Lessee accounting under ASC 842
Like ASC 840, the new lease accounting standard uses a two-model approach for lessees; each lease is classified as either a finance lease or an operating lease. This applies to all leased asset categories covered under the standard, including leases of equipment and real estate. “Finance lease” is a new term and replaces the term, “capital lease,” used under Topic 840.
Lessees reporting under Topic 842 are required to recognize both the assets and the liabilities arising from their leases. The lease liability is measured as the present value of lease payments, while the lease asset is equal to the lease liability adjusted for certain items like prepaid rent and lease incentives.
Among the many changes to lease accounting under this standard, the most significant is that operating leases will be recorded on the balance sheet as lease assets and lease liabilities. The asset is known as the right-of-use asset and represents the lessee’s right to use the underlying asset while the lease liability represents the lessee’s financial obligation over the lease term. When measuring the assets and liabilities, both the lessee and the lessor should also include “reasonably certain” lease renewals beyond the current lease term and “reasonably certain” asset purchase options.
For leases with terms of 12 months or less, lessees can elect to not recognize lease assets and liabilities. They should instead recognize lease expense on a straight-line basis, generally, over the term of the lease, like the accounting treatment under ASC 840.
Existing capital leases will not require adjustment or remeasurement upon transition, but they will be referred to as finance leases.
Lessee lease accounting under ASC 842 - Operating lease
When accounting for an operating lease, the lessee must:
- Recognize a single lease cost allocated over the lease term, generally on a straight-line basis
- Classify all cash payments within operating activities on the statement of cash flows
Lessee lease accounting under ASC 842 - Finance lease
When accounting for finance leases, lessees must:
- Recognize interest on the lease liability and amortization of the right-of-use asset in separate line items of the income statement
- Classify payments of the principal portion of the lease liability within financing activities and payments of interest on the lease liability within operating activities on the statement of cash flows
Lessor lease accounting under ASC 842
Lessor accounting practices remain largely unchanged from ASC 840 to 842. Lessors can classify leases as operating, sales-type, or direct financing leases, but the leveraged lease type under ASC 840 is eliminated under ASC 842. Lessor accounting is covered in full detail in ASC 842-30. No significant changes were made to the requirements for balance sheet recognition.
For operating leases, the leased asset will continue to be recognized as property and equipment on the lessor’s books, whereas for both sales-type and direct financing leases the lessor derecognizes the leased asset and records a net investment in the lease on the balance sheet. While income from operating leases is recognized on the income statement as rental income, when cash is received from sales-type and direct financing leases a portion is applied as a reduction to the net investment in the lease, and a portion is recognized as interest income.
Sale-leaseback accounting under ASC 842
In a sale-leaseback transaction, the lessee sells the asset to the buyer/lessor and enters into an agreement to lease the asset back from the buyer/lessor. This type of transaction consists of both a sale and a lease. The determination of whether the transaction is a sale or not is performed in accordance with ASC 606, Revenue from Contracts with Customers.
As a result of the changes under both ASC 606 and ASC 842, some transactions not qualified for sale and leaseback accounting under ASC 840 will qualify under ASC 842. The opposite is also true: some sale-leaseback transactions under ASC 840 will no longer qualify for this accounting under ASC 842. However, transactions correctly accounted for using sale-leaseback accounting under ASC 840 do not have to be reassessed during the transition to ASC 842.
Leveraged lease accounting under ASC 842
Under Topic 840, a leveraged lease was defined as an agreement in which the lessor borrows funds from a lender to help pay for the purchase of an asset that is then leased to a lessee. The lender holds the title of the asset and the lease payments made by the lessee are collected by the lessor. The lessor is then responsible for sending payments to the lender.
As we mentioned above, ASC 842 essentially eliminates the leveraged lease classification. Lessors can only classify a lease arrangement as a leveraged lease if the commencement date is prior to the effective date of the new lease accounting standard. For private companies that haven’t yet adopted ASC 842, the accounting for leveraged leases under ASC 840 will continue to apply to all leases that meet the criteria. The accounting is detailed in ASC 840-50.
Ultimately, this means no new leveraged leases will be created following the final effective date of the new standard.
ASC 842 disclosure requirements
The disclosure requirements for FASB 842 are both qualitative and quantitative. A few of the specific disclosures required are:
- Discussions covering the lease arrangements
- Descriptions of significant judgments made
- Details about the lease costs reported on the income statement
- Weighted-average analysis of discount rates and remaining lease terms
ASC 842 transition: What companies should be doing to prepare
Start building an inventory of your leases
- Document each lease and its pertinent details in a single place, such as an internally developed template
Begin gathering your embedded leases
- As part of your lease inventorying process, you’ll also need to compile your embedded leases. Some common types of contracts containing embedded leases are listed below as a starting point:
- Security contracts often contain leases for equipment, such as scanners or monitors
- Logistics and transportation agreements may contain language identifying a specific vehicle to be used solely for your needs
- Datacenter contracts may designate specific servers for your company
Prepare for the calculations and disclosures needed under ASC 842
- The disclosure requirements under ASC 842 are much more robust than those required under ASC 840. To be compliant, a series of complex calculations will need to be undertaken each reporting period.
Start evaluating software
- Lease accounting software will save you an immense amount of time, but it does take some upfront work to get the solution up and running.