The vast majority of companies lease some kind of equipment. For large manufacturers this might be a specialized piece of machinery, while for a service provider this may be printers, or other office equipment.
ASC 842, the new lease accounting topic that replaces the old ASC 840, details some very specific ways to deal with equipment leases.
An overview: ASC 842 and equipment lease accounting
Organizations choose to lease for a number of reasons. These range from the convenience of leasing versus purchasing an asset, to tax planning reasons.
Once an organization has leases in place, these then become subject to the rules governing leases according to ASC 842.
ASC 842 itself was first initiated in response to several high-profile accounting scandals, in which “off-balance sheet financing” – often through the use of leases – was used to misrepresent a company’s financial position.
The new standard, or Topic, introduces a number of novel ideas, from the definition of a lease itself, through to the accounting treatment of leases. One of the biggest changes brought about by ASC 842 is that operating leases, which previously could be expensed through the income statement, must now be represented on the balance sheet as a right-of-use asset and lease liability. This of course directly impacts most companies’ equipment leases, and in the next section we’ll look at how to treat such leases under ASC 842.
ASC 842 for equipment leases
ASC 842 defines a lease as “a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.”
While there is a lot to unpack in that short definition, it’s clear that ASC 842 is the relevant standard when it comes to equipment lease accounting.
The first question to ask is whether the lease in question is an operating lease, or a finance lease. ASC 842 provides some detailed guidelines in terms of this test. Essentially, ASC 842 requires companies to test for a finance lease first – and if it is not a finance lease, then an operating lease should be recorded.
Is it a finance lease?
A lease needs to meet any one of the following criteria to be classified as a finance lease at commencement (842-10-25-2):
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term. This is usually stipulated in the lease agreement.
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise. What generally makes this “reasonably certain” is the price at which the lessee can purchase the asset from the lessor.
- 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. For example, if a generator with an estimated useful life of 5 years is leased for 4 years and 10 months, the transaction is essentially a purchase of the piece of equipment, and thus classified as a finance 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 equals or exceeds substantially all of the fair value of the underlying asset. This is essentially the purchase of the asset, though not in full at the time of transferring the asset to the lessee, i.e. a finance lease.
- For both of the previous two points, ASC 842 gives guidance in terms of a “reasonable” approach (842-10-55-2), namely:
- At least 75% of the remaining economic life of the underlying asset is a major part of the remaining economic life of that underlying asset
- A commencement date that falls at or near the end of the economic life of the underlying asset refers to a commencement date that falls within the last quarter of the total economic life of the underlying asset
- At least 90% of the fair value of the underlying asset amounts to substantially all the fair value of the underlying asset
- The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term. Consistent with the other criteria presented, consider a machine that can only produce a certain type of widget, that is patented by the lessee. At the end of the lease, the lessor cannot take back the machine, and therefore the asset is, for all intents and purposes, transferred to the lessee and is thus a finance lease.
From the perspective of a lessee, this is any lease other than a finance lease – or as ASC 842 puts it, “When none of the criteria in paragraph 842-10-25-2 are met, a lessee shall classify the lease as an operating lease.”
Cut through the complications
As we’ve seen, lease accounting under ASC 842 can quickly get quite complex. This is where AI-powered, automated lease accounting software comes into play.
With Trullion, you get such a solution, that does the heavy lifting for you in terms of using software to handle your lease accounting under ASC 842.
- Seamlessly meet compliance requirements
- Produce accurate and consolidated reports in minutes
- Significantly reduce costs and see immediate ROI
- Effortlessly trace your audit trail back to the source data
- Access simple reports and clear financial schedules
- Generate fully compliant disclosures
- Share a live 360° data image of the transactional workflow with key stakeholders
When it comes to your equipment lease accounting, ensure you have technology in your corner to remain compliant with what can be a tremendous challenge.
Trullion is there for you to ensure a smooth, seamless ASC 842 equipment lease accounting experience. To find out more, get in touch.