Last Updated on September 14, 2022 by Morgan Beard
In 2005, the Securities and Exchange Commission recommended FASB address a lease accounting project. One that provides auditors, and businesses with more financial transparency. Under ASC 840, operating leases are off-balance sheet arrangements. Fast forward to today, and ASC 842 is replacing ASC 840 and creating new guidelines that say all lease liabilities should be accounted for on the balance sheet.
The ASC 842 transition date for public companies was Jan. 1, 2019, but private companies were granted an extension giving their teams until Jan. 1, 2022, to transition. The graph below shows transition dates to the new leasing standard based on your fiscal year:
|If Your Year End Is:||You Must Transition To ASC 842 by:|
What Is FASB ASC 840?
ASC 840 is the original lease accounting standard implemented by U.S. generally accepted accounting principles. Under ASC 840, leases were categorized as either capital or operating leases. There is a loophole with ASC 840 that allowed operating leases to be disclosed in the footnotes of a financial statement. Capital (finance) leases are recorded on the balance sheet and measure interest and depreciation expenses.
What’s Changing With FASB ASC 842?
ASC 842 is an effort to create more transparency into an organization’s lease obligations and its financial position. Companies must report all leases on their balance sheets that are 12 months or longer.
The greatest change from ASC 840 to ASC 842 is the recognition of your balance sheet. Operating leases can no longer be reported in the footnotes. Instead, lessees are required to record all assets and liabilities to clearly represent their lease obligations and payments for those assets.
What Do the New Lease Accounting Compliance Mean for Companies?
This ASC 842 transition will require a heavy lift from accounting departments. In practical terms, the new lease accounting standards will mean that more of a company’s contracts will be considered as leases or that they will be judged to contain leases. The standards will also demand that the data and processes associated with these contracts be transparently reported.
This means that companies will need to spend the next few months identifying leases, collecting the data from these leases, and using lease accounting software to assess their inventory of contracts against the new right-of-use asset standards. Companies with large lease portfolios will need to find embedded leases.
Accounting teams will need to take a comprehensive index of assets — even to the point of reviewing outsourced agreements and third-party data — to figure out if contracts contain leases. For many companies, this will mean investing in extra administrative support and lease accounting software in order to make sure they’re fulfilling their reporting obligations and FASB ASC 842 compliance.
Lessee accounting requires technical accounting prowess. Early adoption of the new lease standards is best. The first step to a sound transition method is understanding the Financial Accounting Standards Board Topic 842.
What Are the Key Differences Between ASC 840 and ASC 842?
1. The definition of a lease.
Under the new ASC 842, a lease is defined as a contract that expresses the right to control usage of identified property or equipment (an identified asset) during a particular period of time. The assessment of lease identification requires numerous steps. Here are the four steps to identifying a lease under ASC 842.
2. Lease payments.
Lessors and lessees must determine the lease payment as it relates to the use of the leased asset during the lease term. This determination will assess the payments that are included in the lease calculation at the commencement of the lease, including:
· Fixed payments.
· Variable lease payments that depend on indexes or rates.
· Penalty for lease termination.
· Exercise price of the asset purchase option.
· Fees paid by the lessee to the owner.
· The residual value guarantee.
3. Discount rates.
Choosing the appropriate discount rate starts with using the rate that is implicit in the lease. If the rate isn’t implicit in the lease, then the lessee will have to assume the asset’s fair market value, the residual value, and any direct costs incurred by the lessor. According to FASB’s ASC 842, “The rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term is an amount equal to the lease payments in a similar economic environment.”
The discount rate is used to calculate the current value of lease payments when determining lease classification.
4. Lease classification.
The lease classification — finance or operating — should be determined at the lease commencement date. Equipment leases can fall in either classification. The classification of a lease has a direct impact on measurement, disclosure, and financial statement reporting. The Package of Practical Expedients aids in lease classification election.
Finance leases are defined by these criteria:
· Ownership transfer of the underlying asset.
· Purchase option that a lessee is reasonably certain to exercise.
· Lease term is for the majority of the underlying asset’s remaining economic life.
· Present value of the lease payments substantially exceeds the future value of the asset.
· Underlying asset is specialized in nature.
5. Lease recognition and measurement.
With ASC 842, all leases with a 12-month lease term or longer must be recognized on the balance sheet. Under both ASC 840 and ASC 842, a lease is recognized at the commencement of the lease. A divergence between the ASC 840 and 842 occurs when determining the measurement of a lease:
· Under the old standard (ASC 840), the discount rate, fair value, and lease classification are determined at the lease’s inception.
· With the new standard (ASC 842), the discount rate, fair value, and lease classification are determined at lease commencement.
Lease Recognition Under ASC 842
· A lessee shall recognize a lease liability and right-of-use asset at the commencement date.
· The cost of the right-of-use asset includes the amount of the initial measurement of the lease liability as well as direct costs incurred by the lessee. Lastly, the cost of the right-of-use asset must also include any lease payments made to the lessor, excluding any lease incentives received at the lease commencement date.
· The rate that is implicit in the lease should be used if readily accessible. If it’s not, then the lessee shall use the lease’s incremental borrowing rate.
· The discount rate is used to calculate the present value of lease payments on calculations available at the commencement date.
6. Lease modifications.
A lease modification is a change to the terms and conditions of a contract that results in a change in the scope or the consideration of a lease.
The race is on to get your books in order. For more insights and to consider your options for adapting to ASC 842, take a look at our “Ultimate Guide to Lease Accounting.”
|Extends or reduces the term of an existing lease, other than through the exercise of an option|
|Grants the lessee an additional right-of-use|
|Only results in changes to the consideration in the contract|
|Reduces the scope of the lease through a full or partial termination|
|– Lease classification is reassessed as of the lease modification effective date|
– Consideration is remeasured and reallocated
– Lessee would use the updated lease payments and discount rate to revise the lease liability and adjust the ROU Asset on the basis of the difference
– No income statement impact
Lease Liability Prior To Modification $100,000
Lease Liability After Modification $150,000
Modification Amount $50,000 (Dr: ROU Asset, Cr: Lease Liability)
|– Lease classification is reassessed at the lease modification effective date|
– Consideration is remeasured and reallocated
– Lessee would use the updated lease payments & discount rate to revise the lease liability and adjust the ROU asset in a proportionate manner
– Difference between the proportionate reduction of the ROU Asset and Lease Liability is recognized in the income statement as a gain or loss
The new accounting standards will be a substantial overhaul for finance teams. Teams might need to get more external help to safely and successfully modify their business processes before the deadline. Becoming compliant to the new leasing standard has economic benefits. Especially, as your real estate and finance teams gain a better financial understanding of your cash flows and revenue recognition.
If your team needs help with the transition, set up a demo with Occupier to see how we can help create a more efficient process.