New Lease Accounting Rules
Accounting Standards Codification Topic 842, commonly known as ASC 842, is the new Financial Accounting Standards Board’s (FASB) Lease Accounting standard. It replaces ASC 840, the old accounting standard, and patches a critical flaw: to date, operating leases have been kept off balance sheets.
What is a lease?
To determine whether a contract constitutes a lease, it must answer three criteria. First, the asset must be identified – either a physically distinct asset or an asset in which the lessee receives substantially all its capacity. Second, the lessee must receive almost all of the economic benefits from the asset. Finally, the lessee must have the right to direct the use of the asset.
Just to recap: for a contract to become a lease, there are three guiding criteria:
- Identified asset
- Lessee gets economic benefits of the asset
- Lessee has right to direct use of the asset
What is ASC 842?
ASC 842 is the new FASB lease accounting standard that requires the tracking and disclosure of a company’s leased assets. ASC 842 replaces the previous US GAAP lease standard, ASC 840. Public companies were required to adopt it in 2019 and private companies were required to adopt it in 2020.
ASC 842 is sometimes referred to as FASB Topic 842 and contains guidance on the accounting and financial reporting for agreements meeting the standard’s definition of a lease. The goal of the new standard is to:
- Streamline the accounting for leases under US GAAP
- Enhance transparency into liabilities resulting from leasing arrangements (particularly operating lease contracts)
- Reduce off-balance-sheet activities
Under ASC 842, almost all leases must be represented on the balance sheet with a liability and an ROU asset. Additionally, ASC 842 lease accounting has created transparency with financial statements. Organizations with lease assets must recognize nearly all leases as assets and liabilities, whether classified as operating leases or financing leases, subject to certain exemptions.
For the lessee, lessor, or borrower, the recognition of ASC 842 governed lease-related assets, liabilities, and changes to the timing of the lease expense recognition have had significant lease administration and financial reporting implications. It’s important to have lease accounting software that accurately tracks ASC 842 balance sheet information.
How are lease assets and liabilities calculated under ASC 842?
The leased asset’s value is calculated as the initial liability plus and initial direct costs and payments before commencement, subtracting incentives if there are any.
Right-of-use Asset Value = Initial liability + Initial direct costs + Payments before commencement – Incentives
The lease liability, on the other hand, is the total present value of pending payments, using the discount rate as specified in the lease contract.
Lease Liability = total value of payments * discount rate
Impacts on your organization
The key difference with ASC 842 lease accounting is that operating leases will now go on the balance sheet. In layman’s terms, before this new regulation, leases were just credit card transactions without ever looking at the bill or credit card balance. Now you have to share that balance. That’s the impact on the financial side.
There’s a little more to it. Another big impact is the amount of data that you’ll be required to collect and manage within lease contracts. For example, under ASC 840, you just cared about start date, end date and payment stream. Under ASC 842, however, you also have to collect incentives, allowances, track options and make judgments involving capital lease testing, interest rates, future assumptions around lease performance and more.
How should my organization prepare for ASC 842?
There are two things that you need to think about at the highest level. You need to implement the standard, and you need to implement the process. Implementing the standard is understanding the impacts on your organization at an accounting level, controls and processes. The ongoing process is – how am I actually going to produce my journal entries and disclosures moving forward?
The implementation of the standard needs to be done internally or in conjunction with partners that understand your unique business needs and operational environment. On the process side, implementation is usually done in spreadsheets (for 5 or fewer leases). It can also be done in manual entry lease databases, or – to make matters much easier – with AI-powered software.
Download the Ultimate Guide to Implementing ASC 842
When was the ASC 842 effective date?
The ASC 842 deadline for public companies was effective for reporting periods beginning on December 15th, 2018, i.e. from financial years ending December 31 for most organizations. For private companies and non-profit organizations, ASC 842 was originally set to go into effect for financial years starting 1 January 2020. Due to COVID-19 and providing relief to companies, the decision was delayed again in June 2020 and therefore the standard went into effect for annual reporting periods beginning after December 15th, 2021, which would be the financial year 2022 for most companies.
Which industries are most affected by ASC 842?
Any organization that makes use of leases is affected by ASC 842. However, the impact of ASC 842 can vary depending on the industry. Industries that typically have a large number of operating leases, or are reliant on leasing instead of purchasing assets will be significantly impacted.
How does ASC 842 differ from ASC 840?
The main difference is that under ASC 840, lease classification (determining if a lease is an operating or capital lease) was decided when the lease went into effect (i.e. lease inception). However, under ASC 842, lease classification (finance or operating) is decided at lease commencement.
How can I learn more?
Here are some resources you might find useful.
Deloitte’s roadmap to applying ASC 842
PwC’s lease accounting guide
EY’s closer look at the new lease accounting standard