With the ASC 842 adoption deadline for private companies approaching quickly, we’ve approached our CPA experts to answer your most frequently asked questions about the standard.
As a refresher, ASC 842 is the new Accounting Standards Codification for leases. ASC 842 replaces ASC 840, and requires, amongst other things, for lessees to recognize lease assets and liabilities on the balance sheet instead of being able to expense operating lease expenses through the income statement.
The impact on net income will depend on the mix of operating and finance leases, as well as the level of discounting applied to the lease liabilities. The new standard also introduces a number of new disclosures, including information about the nature and amount of leased assets and liabilities, as well as significant judgments and estimates made in applying the standard.
Below, you will find the answers to the most commonly asked questions companies have about the adoption and implementation of ASC 842.
Who must comply with ASC 842?
ASC 842 applies to all companies that enter into leases. This includes both lessees and lessors. ASC 842 replaces ASC 840, which only applied to lessees. Thus, ASC 842 has a much broader scope than its predecessor. ASC 842 must be applied using a modified retrospective approach, which means that it should be applied to leases that exist at the time of adoption.
ASC 842 contains many detailed provisions and disclosures that will need to be considered when applying the standard. Some of the key provisions and disclosures include:
- Determining whether a contract is or contains a lease
Identifying the components of a lease
Allocating the consideration in a contract to the various components of the lease
Recognizing lease income and expenses
Disclosing information about leases
Do private companies need to follow ASC 842?
For public companies, the ASC 842 deadline was effective for reporting periods beginning from December 15, 2018 (from financial years ending December 31 for most companies). For private companies, and nonprofits, the standard was initially slated go into effect for financial years starting January 1, 2020. This decision was then delayed and delayed again in June 2020 to provide relief to companies due to COVID-19, with the standard becoming applicable for annual reporting periods beginning after December 15, 2021, which for most companies would be financial year 2022.
Thus, the ASC 842 deadline for private companies is the period subsequent to December 15, 2021.
What is considered a lease under ASC 842?
There are a few key things to keep in mind when it comes to ASC 842 and what is considered a lease. While there is a specific definition in the standard, generally a lease is defined as an agreement between two parties in which one party agrees to provide the other party with the use of an asset for a period of time in exchange for periodic payments. This definition applies regardless of whether the underlying asset is real estate, personal property, or equipment.
In addition, ASC 842 requires that leases be classified as either operating leases or finance leases. Operating leases are typically shorter in term and do not transfer ownership of the asset to the lessee at the end of the lease term. Finance leases, on the other hand, are typically longer in term and do transfer ownership of the asset to the lessee at the end of the lease term.
Finally, ASC 842 also requires that leases be accounted for on the balance sheet by creating a right-of-use asset and lease liability. Right-of-use assets represent the lessee’s interest in using an asset over the lease term, while lease liabilities represent the corresponding obligation to make lease payments.
How has lease classification changed under ASC 842?
ASC 842, which is also known as the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) Topic 842, Leases, represents a major shift in how leases are accounted for in financial statements.
Under ASC 842, leases are classified as either operating leases or finance leases. Operating leases are those that don’t transfer ownership of the leased asset to the lessee at the end of the lease term, while finance leases are those that do.
Operating leases, on the other hand, didn’t meet any of those criteria. As a result, they were accounted for differently than capital leases. Capital leases were treated as if the lessee had purchased the asset outright, with the corresponding liability appearing on the balance sheet. Operating leases, meanwhile, were not recorded on the balance sheet at all. Rather, they were expensed as they were incurred.
The new ASC 842 standard requires both operating and finance leases to be recorded on the balance sheet as a right-of-use asset and a corresponding lease liability. This is true regardless of whether the lease term is greater than or less than 75% of the asset’s useful life or whether the present value of the lease payments is greater than or less than 90% of the asset’s fair value.
The impact of ASC 842 has been far-reaching, affecting both lessees and lessors. For lessees, the most visible change has been the addition of lease assets and liabilities to their balance sheets. This can have implications for a company’s financial ratios, such as its debt-to-equity ratio and its asset turnover ratio. For lessors, ASC 842 has resulted in changes to the way they recognize revenue from leases.
How do you account for finance leases under ASC 842?
ASC 842 requires lessees to recognize a right-of-use asset and a lease liability on the balance sheet for all leases with terms greater than 12 months. Lessees are also required to disclose information about their material leases. For finance leases, ASC 842 requires that the leased asset and related lease liability be recognized at the inception of the lease. The carrying amount of the leased asset is equal to the present value of the minimum lease payments over the term of the lease. The interest rate used to calculate the present value of the minimum lease payments is the implicit rate if that is readily determinable, or if not, then the lessee’s incremental borrowing rate should be used.
The leased asset in finance leases is depreciated over its useful life on a straight-line basis. The lease liability is recognized as an interest-bearing liability and is measured at amortized cost using the effective interest rate method. Payments of principal and interest are recognized in the income statement as lease expenses. ASC 842 also requires lessees to recognize impairment charges on their leased assets in accordance with ASC 360, Property, Plant, and Equipment.
For lessors, ASC 842 requires that finance leases be accounted for as operating leases. Operating leases are not recorded on the balance sheet but are instead recognized as lease revenue on a straight-line basis over the term of the lease. ASC 842 also requires lessors to recognize impairment charges on their leased assets in accordance with ASC 360.
What are examples of ASC 842 lease accounting?
An example of lease accounting would be as follows:
A contract between Acme Limited (the Customer) and Wiley E Trucking (the Supplier) provides the Customer with the use of 10 trucks of a particular type for 5 years. The contract specifies that the trucks are owned by the Supplier.
Per the contract, the Customer determines the goods that are to be transported using the trucks. When the trucks are not in use, they are kept at Customer’s premises. If a particular truck needs to be serviced or repaired (the trucks were specifically identified in the contract), the Supplier is required to substitute a truck of the same type.
In this case, the Customer has the right to control the use of the 10 trucks throughout the 5-year period because:
The Customer has the right to obtain substantially all of the economic benefits from use of the trucks over the period of use. The Customer has exclusive use of the trucks throughout the period of use, including when they are not being used to transport the Customer’s goods
The Customer has the right to direct the use of the trucks. Within the scope of its right of use defined in the contract, the Customer makes the relevant decisions about how and for what purpose the trucks are used by being able to decide when and where the trucks will be used and which goods are transported using the trucks. The Customer also determines whether and how the trucks will be used when not being used to transport its goods.
(Adapted from ASC 842 842-10-55-41)
The contract contains a lease, and should be accounted for according to ASC 842.
Recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments, in the statement of financial position
Recognize a single lease cost, calculated so that the cost of the lease is allocated over the lease term on a generally straight-line basis
Classify all cash payments within operating activities in the statement of cash flows
Ensure to account for any modifications
Subsequently, the following treatment is required: the lease liability is measured at the present value of outstanding lease payments, while the right-of-use asset is measured at this amount adjusted for specific elements listed in ASC 842, such as prepaid or accrued lease payments.
What types of leases are excluded from the new lease standard?
ASC 842, the new lease accounting standard, excludes certain types of leases from its requirements. These include leases of inventory, property held for sale, and intangible assets. ASC 842 also exempts short-term leases (those with terms of 12 months or less) and low-value assets (those with an estimated useful life of 75% or less of the lease term) from many of its provisions. As a result, these types of leases will not be reported on the balance sheet as liabilities. However, they will still be disclosed in the footnotes to the financial statements.
In addition, ASC 842 excludes certain types of embedded leases from its requirements. These include leases of land, buildings, and equipment that are leased together with other goods or services. ASC 842 also exempts leases of assets that are not used in the ordinary course of business from many of its provisions. As a result, these types of leases will not be reported on the balance sheet as liabilities. However, they will still be disclosed in the footnotes to the financial statements.
Is there a low-value lease threshold under ASC 842?
Yes, there is a low-value lease threshold under ASC 842. ASC 842 requires leases with a term of 12 months or less, and that are expected to have a value of $5,000 or less at inception, to be classified as low-value leases. Low-value leases are not subject to the requirements for recognition and measurement of leased assets and leased liabilities. Instead, they are accounted for as operating leases.
How is lease liability calculated under ASC 842?
ASC 842 requires that lessees recognize a lease liability and a right-of-use asset for all leases with terms greater than 12 months. The lease liability is equal to the present value of the lease payments. The right-of-use asset represents the lessee’s right to use the underlying asset during the lease term. ASC 842 also requires that lessees disclose information about their leasing activities, including information about their significant leasing arrangements.
Lessees must determine the present value of lease payments using the implicit rate if that is readily determinable, or if not, then the lessee’s incremental borrowing rate.
ASC 842 requires that lease liabilities be measured at inception, and thereafter at each reporting period end, using one of two methods: the effective interest method or the discounted cash flow method.
The effective interest method results in periodic amortization of both the lease liability and the right-of-use asset that is equal to the interest expense on the lease liability. The periodic amortization of the right-of-use asset using the effective interest method also results in a corresponding straight-line accumulation of depreciation expense on the income statement.
The discounted cash flow method results in a single lump-sum payment of both the lease liability and the right-of-use asset at inception. There is no periodic amortization of either the lease liability or the right-of-use asset using the discounted cash flow method; however, there is a corresponding accumulation of depreciation expense on the income statement that is equal to the sum of all future lease payments discounted at the lessee’s incremental borrowing rate.
ASC 842 requires lessees to disclose information about their leasing activities, including information about their significant leasing arrangements. Lessees must disclose the amount of the liability recognized for leases, as well as the weighted-average remaining lease term and weighted-average discount rate used to calculate the lease liability. Lessees must also disclose information about their rights-of-use assets, such as the carrying value and depreciation expense. In addition, lessees must disclose information about their sublease activity, if any.
Implementing the requirements of ASC 842 can seem daunting at first – and without the correct tools, it really can be difficult to comply with. However with the right technology partner, implementing ASC 842 and maintaining compliance can be a breeze.
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