New Lease Accounting Rules
Accounting Standards Codification Topic 842, commonly known as ASC 842, is the new Financial Accounting Standards Board’s 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
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 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 judgements involving capital lease testing, interest rates, future assumptions around lease performance and more.
When does ASC 842 go into effect?
Public companies have already adopted the new regulations on January 2019.
For private companies, the adoption deadline is January 2021.
How should my organization prepare?
There’s 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.
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