Lessor vs Lessee Under ASC 842

Lessee? Lessor? Both? Implementing ASC 842 can be confusing, especially when it comes to the differences between the requirements for a lessor and a lessee. What has changed since ASC 840? What’s remained the same? 

ASC 842 provides guidance for both lessors and lessees, and with ASC 842 becoming mandatory for all companies in the (very) near future, understanding the key requirements from both a lessor and lessee perspective is critical in ensuring the successful implementation of the standard. 

Background for lessors and lessees within ASC 842

ASC 842 was introduced with a number of goals in mind. Among these goals was providing useful information to the users of financial statements. Part of the background to this was a number of financial scandals that had been uncovered where off-balance sheet financing, often involving leases, was used – and ASC 842 sought to remove both lessors’ and lessees’ ability to use such opaque accounting practices.

ASC 842 thus made a number of important changes; most notably by ensuring that operating leases are no longer expensed through the income statement, but appear on the balance sheet. The standard, or Topic, also ensures that much more robust disclosures are required by both lessees and lessors to enable all users of financial statements to gain a clearer understanding of a company’s financial situation, and make it more difficult for companies to “hide” payments and liabilities. 

Lessor accounting under ASC 842

First, we turn our attention to lessors. Of the two categories (lessors and lessees), it’s lessors who have seen fewer changes under ASC 842. 

Recognition

There are three major types of leases for lessors discussed in ASC 842. These are sales-type leases, direct financing leases and operating leases. We’ll primarily focus on operating leases. 

For an operating lease, at the commencement date, a lessor must defer initial direct costs. After commencement, a lessor should recognize lease payments as income in profit or loss over the lease term, on a straight-line basis (unless another basis allowed by the Topic is more appropriate.) If lease payments are variable, these should be recognized in the period in which the factors that are related to the variable nature of the lease occur. 

Initial measurement

In terms of initial measurement, lessors should continue measuring the underlying asset as is required by the other relevant topics. 

Subsequent measurement

For the purposes of subsequent measurement, lessors should continue to measure the underlying asset in accordance with the other relevant topics – for instance by testing for impairment. 

Disclosure

Lessors are required to disclose “qualitative and quantitative” information about their leases; the level of detail required is largely up to the lessor, but is governed by ASC 842 which has many stipulations in terms of what must be disclosed. Disclosures must include:

  • The leases themselves
  • Significant judgments made
  • Amounts recognized in the financial statements that relate to the leases specified

Additionally, lessors must disclose a general description of its leases, the terms and conditions for any variable lease payments, terms relating to options to cancel or extend a lease, and the conditions in which the purchase of the underlying asset is allowed. 

Other Topics that apply generally to disclosure apply here, such as any related party information.  

Next, we turn our attention to accounting from a lessee’s perspective.

Lessee accounting under ASC 842

As we discussed, lessees underwent a more comprehensive change in terms of ASC 842. This went right to the heart of what a lease is, and for many companies this means re-evaluating contracts to ensure that a lease is not present. At a high level, accounting for lessees involves the following:

Recognition

At the commencement date, an asset and a liability should be recognized; specifically, a right-of-use asset and a lease liability.

Initial measurement

The lease liability is measured at the present value of all upcoming lease payments, using the discount rate of the lease. The discount rate is the “rate implicit in the lease” – should this be difficult to determine, the company’s incremental borrowing rate can be used. 

The right-to-use asset is initially measured, at commencement date, as the amount of the lease liability, any lease payments made (net of lease incentives received), and certain direct costs incurred. 

Subsequent measurement

Subsequent measurement is as follows:

For the lease liability: the present value of outstanding lease payments, discounted using the discount rate for the lease. 

For the right-of-use asset: the lease liability, adjusted for prepaid or accrued lease payments, any other lease incentives received, unamortized initial direct costs and any impairment for the asset. The right-of-use asset should be amortized on a straight-line basis (in most circumstances), and tested for impairment.

If there is a change in certain aspects of the lease, ASC 842 has specific rules to follow; the Topic also includes examples in this regard. Note that the above is for an operating lease as opposed to a finance lease.

Disclosure

The overall disclosure required by ASC 842 from lessees is similar to that of lessors, namely:

  • An organization’s leases
  • Significant judgments made
  • Amounts in the financial statements relating to leases

Lessees should include general descriptions of leases, terms and conditions of variable leases and options to extend or terminate leases, residual value guarantees, and any restrictions or covenants imposed by lease agreements.

Disclosures should also include details regarding leases that have not yet commenced but that will create significant rights and obligations, assumptions made and how the discount rate used was determined. 

Lessee and lessor accounting under ASC 842

While the introduction of a new Topic – in this case ASC 842 – is bound to cause much discussion and no small amount of confusion, the good news is that many companies have already shown that complying with ASC 842 is within reach, and doesn’t have to be painful.

The secret? Technology.

As both a lessor and lessee, trying to manually comply with ASC 842 is challenging to say the least. And as the number of leases increases, so does the complexity of remaining compliant and error-free.

That’s why companies are turning to automated lease accounting software. Trullion’s seamless AI-powered solution can get you ASC 842 compliant within 30 days, and ensure that staying compliant is a piece of cake thanks to its AI-powered automation.

Interested in learning more? Get in touch with a Trullion team member today: https://trullion.com/contact-us/ 

 

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