ASC 842 - What You Need To Know
FASB has released a new lease accounting standard
by Lucas Russell | 2021-10-19
FASB (the Financial Accounting Standards Board) is an independent nonprofit organization that sets the accounting rules for public and private companies in the United States. In other words, they develop, update, and interpret generally accepted accounting principles (GAAP) for public and nonpublic entities.
Many private companies and all public companies adhere to these accounting standards to ensure consistent financial reporting. For example, the Securities and Exchange Commission (SEC) mandates FASB’s GAAP to public companies in the United States.
Because of this, a significant number of U.S. companies must pay attention to standards released by FASB.
It is not uncommon for the FASB to release new accounting standards to ensure a set of financial statements gives a correct reflection of an organization’s financial position and performance.
One of their latest releases has been FASB ASC 842. This is a new accounting standard that focuses explicitly on lease accounting. FASB ASC 842 will supersede FASB ASC 840, which was the previous lease accounting standard in effect.
The new lease accounting standard, FASB ASC 842, has been released to reflect a company’s business activities better. However, FASB decided that ASC 840 was outdated, and the accounting presented was not providing helpful information to the users of financial statements.
So how did FASB come to this conclusion? Under ASC 840, a company that heavily relies on leased assets such as an airline would have relatively few assets on its balance sheet. That’s because these assets were leased. As a result, many companies had significant off-balance sheet transactions that readers of their financial statements could not get a good picture of. However, when a company adheres to FASB ASC 842, most leases are recorded on the balance sheet.
When is FASB ASC 842 effective?
It has been known for a significant period of time that FASB was in the process of updating the principles of lease accounting, with the objective, as mentioned above, to remove the majority of off-balance sheet transactions. The first announcement that came from FASB was in February 2016 when they released the Accounting Standards Update (ASU) No. 2016-02, also known as ASU 2016-02.
Since its release in February 2016, the standard has been updated several times. However, the core principles have not changed; now, all leases, including operating leases, will be accounted for on the balance sheet. Thus, the accounting is similar to a capital lease under ASC 840.
Also, ASU 2016-02 includes the effective dates of the standards for public and private companies. These dates differ for each type of entity.
FASB ASC 842 effective date for public companies
The date effective for ASC 842 for a public company was for reporting periods that started after December 15, 2018. For example, for a company with a December 31 year-end, that standard was effective from January 1, 2019. As a result, public companies within the United States have been complying with new lease accounting standards for several years.
FASB ASC 842 effective date for private companies
The date effective for ASC 842 for a private company is now for reporting periods that start after December 15, 2021. Thus, for example, for a company with a December 31 year-end, ASC 842 is effective from January 1, 2022.
FASB ASC 842 effective date for private companies delayed in both 2019 and 2020
In ASU 2016-02, the original effective date for ASC 842 for private companies was December 15, 2019. A company with a calendar year-end would be January 1, 2020, a year after it was effective for public companies.
First delay for private companies
However, on October 18, 2019, FASB announced that ASC 842 would be delayed until December 15, 2020. As a result, for companies with a December 31 year-end, that standard would be effective from January 1, 2021. The delay of ASC 842 was to give ASC 842 additional time to prepare for the new lease accounting requirements. This was based on the feedback from public companies on the complexities experienced when adopting FASB ASC 842.
Second delay for private companies
FASB then delayed ASC 842 a second time on June 3, 2020. The second delay of ASC 842 occurred to give private companies accounting relief due to the COVID-19 pandemic. The transition date to ASC 842 was delayed until December 15, 2021. As a result, the standard is now mandatory for private companies with a December 31 year-end from January 1, 2022.
How does ASC 842 change lease accounting?
All leases are captured on the balance sheet
The change in accounting resulting from the adoption of ASC 842 has garnered a lot of attention, arguably the most for an individual accounting standard. Here are some of the headlines:
The headlines from the CFO Journal are more attention-grabbing than substance. However, as noted by the Financial Times, $3 trillion of leases will be added to balance sheets globally. This is the essence of what the new lease accounting standard FASB ASC 842 has set out to do, in combination with the IASB’s new lease accounting standard IFRS 16, which applies to the rest of the world.
How is lease accounting different under ASC 842?
The changes under ASC 842 are very specific to a particular role in the standard. For example, under ASC 840, the previous lease accounting standard, a lessee had to determine if the lease they had entered into was an operating or capital lease. Although the lease classification test remains for a lessee under ASC 842, capital leases are now referred to as finance leases.
The significant divergence from ASC 840 that created the above headlines is that the accounting for an operating lease has completely changed for a lessee. Under ASC 840, an operating lease was expensed to the income statement. The accounting was extremely straightforward. Under ASC 842, a lessee, when accounting for an operating lease, now must measure a liability and asset. The liability represents the future payments in relation to the lease and is referred to as the lease liability. The asset represents the right to use the leased asset, which is called the right of use asset.
To calculate the lease liability, a company is required to present the value of the lease payments. There are several caveats of how to calculate the lease liability and right of use asset. Nevertheless, the accounting is very similar to that of a capital lease under ASC 840.
For more information on how to calculate the lease liability and right of use asset for an operating lease, the following material might be helpful:
The new lease accounting standard is significantly more complex for lessees
The key is with this change in accounting under the new lease accounting standard, compliance under ASC 842 is far more rigorous. That’s because most leases meet the definition of an operating lease.
Because of these requirements, you’ll notice several companies that provide software that will automate a company’s requirements with ASC 842. The fact that these companies exist and are used is good evidence that the manual upkeep is significant.
The scope of ASC 842
One of the most important aspects of transitioning to the new lease accounting standard is identifying all the applicable transactions captured under ASC 842 and meet the definition of a lease.
Under ASC 840, the key judgment area was determining if the lease was an operating or capital lease. As under the previous lease accounting standard, that was the determining factor if the lease was captured on the balance sheet or not.
Given under ASC 842, regardless of whether the lease is a finance or operating lease, it will be accounted for on the balance sheet. The key judgment call moves upstream to is the contract a lease or not.
A critical risk a company faces is that contracts that meet the definition of a lease are missed. This would not be material under the previous lease accounting standard as the lease would likely be an operating lease and expensed to the income statement. However, under ASC 842, if an operating lease is missed, it can have a material impact on a company’s financial statements.
Definition of a lease under ASC 842
There are three main criteria when identifying a lease under ASC 842:
| 842-10-15-9: Is there an Identified asset? | |
|---|---|
| Criteria to be met | Explanation |
| Implicitly or explicitly stated | The lease contract does not have to specify an asset. For example, a specialized piece of machinery that manufactures customized products. |
| Physically distinct / majority of the total capacity | The asset must be physically distinct. For example, floor 52 on a hundred-floor building. If that’s not the case,e the lessee must have the right to substantially all of the capacity, i.e., 95% of the warehouse floor space |
| No substitution rights from lessor | Lessor has the right to substitute the asset throughout the life of the lease, and the lessor would benefit economically from substitution |
| 842-10-15-17: Does the lessee obtain substantially all of the economic benefits? | |
|---|---|
| Criteria to be met | Explanation |
| The customer has the right to substantially all of the economic benefits from the use |
To determine this, the following considerations need to be made:
|
| 842-10-15-20: Does the lessee direct the use? | |
|---|---|
| Criteria to be met | Explanation |
| The customer makes the ‘how and what purpose decisions’ in order to make the contract is a lease | If the customer makes the ‘how and what purpose decisions’ then the contract is considered a lease. Conversely, if the supplier makes those decisions, then the contract is not a lease, but a service contract. |
Noting this definition, it’s imperative to revisit any contracts that may meet the above criteria. In addition, at year-end, the “completeness” of the lease accounting balances will be something the auditors have identified as high risk. As a result, a contract that may have an embedded lease will be a significant focus of their audit procedures.
If you would like further detail on what contracts meet the definition of a lease and identify embedded leases, I’d recommend Deloitte’s ASC 842 guide, which is highly detailed.
Given the transition to ASC 842 for privates is on December 15, 2021, it’s imperative to start identifying these leases as it’s one of the biggest challenges when transitioning to the new lease accounting standard.
Leases in the scope of ASC 842 and the short term scope exception
Once a company has identified all contracts that meet the definition of a lease, there is a scope exemption provided by the standard setters. If the contract is for twelve months or less, it can be exempt from the balance sheet recognition model and expensed to the income statement.
What companies need to comply with ASC 842?
Any company that needs to present financial statements in compliance with the FASB’s GAAP. This is likely to be companies that are domiciled in the United States. In addition, depending on companies reporting requirements, they also may need to comply with IFRS 16.
IFRS 16 is the new lease accounting standard applicable to the rest of the world released by the IASB. Unless a United States-based company has operations outside the U.S., it’s unlikely that IFRS 16 is applicable.
What are the differences between IFRS 16 and ASC 842?
The IASB and FASB original goal was to harmonize the two lease accounting standards. Doing this would reduce the regulatory burden for those companies that need to comply with both standards. For the most part, this did happen. Unfortunately, however, the two standards did diverge.
ASC 842 keeps the lease classification
The most significant difference between ASC 842 and IFRS 16 is ASC 842 retains the lease classification of an operating and finance lease. While with IFRS 16, there’s only one lease type. The accounting for a lease under IFRS 16 closely resembles that of a finance lease under ASC 842.
IFRS 16 is now effective
In addition, IFRS 16 has been in effect since January 1, 2019. This includes both public and private companies. Although ASC 842 has been mandatory for public companies on the same date as IFRS 16, private companies in the US, as mentioned above, will be required to adopt on December 15, 2021.
Accounting differences
Under ASC 842, adjustments to an index or rate do not constitute a reassessment event. Furthermore, for an operating lease under ASC 842, interest and amortization incurred are deemed a “lease expense.” Because of this, an operating lease has the same impact on the income statement as it did under ASC 840. As a result, IFRS 16 has a far more significant impact on financial ratios such as EBITA.
In addition, the make good provisions/asset retirement obligations in relation to the leased assets are added to the value of the right of use asset under IFRS 16, while they are accounted separately under ASC 842.
KPMG provides a good summary of all the differences between ASC 842 and IFRS 16 here.
Similarities between IFRS 16 and ASC 842
The two standards have more in common than not, especially at the initial recognition of the lease liability and right of use asset. The calculation of the lease liability is the present value of the known future payments. With the right of use asset derived from the lease liability, considering several additional inputs.
There are many ways to calculate the present value of a future set of cash flows. For an in-depth discussion on present value calculation methodologies, refer here.
The similarities between calculating a finance lease under ASC 842 and IFRS 16 are closer than the calculations between an operating lease and a finance lease under ASC 842.
ASC 842 accounting requirements
The accounting requirements necessary to comply with ASC 842 are extensive. The easiest way to tackle the requirements is by the role in the leasing transaction being the lessee and lessor.
Lessee accounting treatment under ASC 842
The lessee must determine if the lease is classified as operating or finance. The classification criteria have slightly changed from ASC 840. For further details on how to determine the classification of the lease, refer here.
Operating leases
The fundamental change under ASC 842 is that operating leases come on the balance sheet. As a result, the lessee is required to calculate a lease liability. A lease liability is the present value of the future lease payments at a point in time. The debit side of the journal entry is the right of use asset.
We also have a practical example of how to calculate the lease liability and right of use asset throughout the lease. Refer to How to Calculate the Lease Liability and Right-of-Use Asset for an Operating Lease under ASC 842. This example also includes modification accounting.
The example will also highlight calculating the ROU asset amortization expense, the most significant difference between calculating a finance lease under ASC 842.
Finance leases
For a company with capital leases under ASC 840, the accounting under ASC 842 is fundamentally the same. The lease continues to be captured on a company’s balance sheet. Just remember that capital leases are now referred to as finance leases.
For more information on accounting for a finance lease, refer to How to Calculate a Finance Lease under ASC 842.
Difference between an operating lease and finance lease under ASC 842
The calculation of the lease liability is consistent between the two classifications. However, as mentioned above, the calculation of the right of use asset amortization differs. In addition, the classification of interest and amortization differs. With operating leases, they’re considered a “lease expense.” This difference is one of the main reasons the FASB decided to keep the lease classification model.
For a detailed analysis of the difference between the two lease classifications, refer here.
Lessor accounting
Lessor accounting remains fundamentally the same under ASC 842 when compared to ASC 840. The three lease classifications remaining being:
- Operating lease: the lessor continues to recognize the leased asset on their balance sheet. Therefore, income received from the lease payments is recognized as rental income.
- Sales-type or direct financing: The lessor will continue to derecognize the leased asset and recognize a net investment in the lease. This receivable is offset with the lease payments, with a portion of the payment being recognized as interest income.
One change under ASC 842 is the leveraged lease type under ASC 840 is eliminated.
Overall from a lessor perspective, it’s very much business as usual. However, the transition to the new lease accounting standard may provide an excellent opportunity to reassess the financial reporting processes for lease accounting. For example, Cradle can automate all the required lessor accounting no matter the lease classification. As a result, a company can automate all of its lease accounting requirements.
Transition practical expedients
Before beginning the transition process to the new lease accounting standard, ASC 842, it’s vital to understand the practical expedients available.
The practical expedients available are something most companies will want to implement when adopting ASC 842. The purpose of these practical expedients is to reduce the workload when adopting the new lease accounting standard. If a company wants to make the transition to ASC 842 as simple as possible, you will want to utilize these practical expedients.
Here are the following practical expedients we’d recommend adopting:
- Transition method: In July 2018, FASB released ASU 2018-11. In this release, the FASB allowed prospective adoption of ASC 842. In other words, a company would not be required to restate its financial statements as if ASC 842 was always in effect. This dramatically reduces the work involved when adopting the standard. For detailed analysis on the transition methods available when adopting ASC 842, refer here.
- Package of practical expedients:
As mentioned previously, ASC 842 has several new definitions that start with the definition of a lease. In addition, the lease classification criteria for determining an operating and finance lease have been updated. With this package of practical expedients, it allows a company, when adopting ASC 842, to not have to reassess if, firstly, the lease is in the scope of ASC 842 and then the lease classification. As a result, a significant amount of time can be saved by utilizing the package of practical expedients. - Discount rate: ASC 842-20-30-3 provides a practical expedient for private entities that allows a lessee to use a risk-free rate for a period comparable to the lease term for the discount rate. Originally this was to be applied at a company-wide level for all a company’s leases. However, on September 15, 2021, FASB released a tentative board decision where this could be applied by asset class. Determining the discount rate arguable requires the most amount of judgment and work. The use of this practical expedient can save a company a significant amount of time. For further information on determining the discount rate, refer here.
How to prepare for the new lease accounting standard
Proper preparation prevents poor performance, and the adoption of ASC 842 is no exception to this rule.
A calculated approach will help with the transition. Of course, every organization is different, but here are some steps to follow that might be helpful:
- Identify all possible contracts in the scope of the standard: Now, you’re probably saying, well, I’m going to apply the package of practical expedients, so I should be fine. However, a double-checking to ensure no missed contracts with embedded leases could prevent a material misstatement when the auditors come.
- Once you have identified the total number of leases, the finance team will need to decide if compliance with be achieved manually or with software.
Manual compliance Vs. lease accounting software
There are two ways a company can comply with ASC 842, one being manual compliance and the other using software.
The referenced articles above, such as how to calculate an operating and finance lease, highlight the work involved when complying with the standard manually. It’s no easy task.
Accounting for ASC 842 manually is a lot of work
For every lease, two calculation schedules must be maintained. One for the lease liability and right of use asset. Not to mention how the lease liability is calculated is entirely different from the right of use asset. Yet when a modification occurs, both schedules must be updated, which is akin to resetting the calculations.
Then each month, the calculation needs to be revisited to determine the movement in the balances and the journal entries.
So why would any company want to do this if there’s a way of automating all this? The most considerable determination is the number of leases. For most solutions on the market, it’s simply not worth the cost as they don’t offer packages for leases less than twenty, nor even advertise pricing. In addition, accounting for two or three leases manually is manageable.
$99 a month to comply
Although this is a shameless plug, I think it’s worth mentioning for your company’s benefit. Cradle offers a $99 a month package that allows you to automate up to 10 leases. We have companies that use this to manage just one lease, and they have the piece of the mind that the calculations are done correctly to the cent. If the finance team spends more than one hour combined on lease accounting a month, which is likely to be yes, the return on investment is easy to justify. Refer to our pricing page for more information.
Lease accounting software makes compliance with large lease portfolios manageable
If your lease portfolio is thirty leases or more, manual compliance becomes very cumbersome, and it’s worth shopping around the software solutions, given the investment is more significant.
Refer to an article here that provides a guide on selecting the lease accounting software that is most appropriate for your company.
Factor in time for either manual calculations or selection of software
If you’ve decided to comply manually or use software, appropriate budgeting of the company’s resources will be needed to prepare the manual calculations for the transition or procurement process of lease accounting software and then onboarding the lease information into the software.
To forecast the manual time spent, it’s probably worth calculating at least one lease manually first and extrapolating over the lease population. With easy-to-use software, and the company has easy access to critical lease information, e.g., start dates and payment amounts, one individual can comfortably onboard more than fifty leases a day.
Conclusion
This article has essentially has provided an overall foundation of everything you need to be aware of when transitioning to ASC 842. If specific detail is required, visit our Insights page, and it’s likely to be answered. If it’s not, let us know at [email protected], and we’ll be happy to help.