Summary of Changes under ASC 842: Become Compliant with New Lease Accounting Standards
Significant changes to lease accounting standards have been implemented for public, private, and nonprofit entities for fiscal years beginning after December 15, 2018 and December 15, 2021, respectively. The new leasing standards represents one of the most comprehensive changes to accounting standards in recent years. With this recent update it is essential for executives and accounting professionals to be made aware for proper implementation and compliance with the new standards. This article will serve as a resource or guide to assist in this objective.
Canva – Mikhail Nilove
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In February 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02, Leases (ASC 842), replacing and modifying the existing financial accounting and reporting for lessees and lessors. This update is widely regarded to be the first comprehensive revision of lease accounting since the publication of FAS 13 in 1976.
The new guidance will affect entities across all industries because most businesses engage in contracts that include leases of all types to support company operations. Although, this update has a substantial impact on the balance sheets of lessees, the lessor’s accounting has also been revised to align with the changes to the lessees’ accounting and specific features of the new revenue recognition standard.
The new lease guidance introduces significant changes to lease accounting, such as “lessees’ recognition of lease assets and liabilities, an exception for short-term leases, elimination of leveraged leases, new criteria for reporting sale-leaseback transactions, increased use of judgment, and expansive disclosures.” Entities must use a modified retrospective approach to reflect the effect of the new guidance in the earliest year presented in the financial statements. As a result, the implementation of ASC 842 could significantly impact a company’s financial operations – from general accounting and financial reporting, treasury, taxation, and budgeting to forecasting tasks.
As a result, it is important for entities that were required to adopt the lease standard on January 1, 2022, ensure their organization follows the update and that leases are appropriately reflected in their interim and annual financial statements prepared in accordance with generally accepted accounting principles (U.S. GAAP).
ASC 842 effective dates
The new lease accounting standard has various effective dates for public and private entities.
Effective date of ASC 842 for public companies:
For public companies, the FASB standard becomes effective for reporting periods beginning after December 15, 2018. For calendar-year-end businesses, this means the standard went into effect on January 1, 2019.
Effective date of ASC 842 for private companies:
ASC 842 takes effect for annual reporting periods beginning after December 15, 2021, for private corporations and nonprofit organizations. This implies that many private businesses and nonprofit organizations are currently through the lease accounting transition.
What is ASC 842, and what is the Definition of Leases under ASC 842 (https://leasequery.com/blog/asc-842-summary-new-lease-accounting-standards/)
ASC 842 is the new lease accounting standard for public and nonpublic entities reporting under US GAAP, superseding ASC 840. ASC 842 is sometimes referred to as Topic 842 and contains guidance on the accounting and financial reporting for agreements meeting the standard’s definition of a lease. The goal of the new standard is to:
● Streamline the accounting for leases under US GAAP
● Enhance transparency into liabilities resulting from leasing arrangements (particularly operating lease contracts)
● Reduce off-balance-sheet activities
ASC 842 defines leases as contracts, or portions of contracts, granting “control” of an identifiable asset for a specific period of time in exchange for payment. The term “control” carries a distinct meaning in this definition. In order to demonstrate control of an asset, a business entity must be able to obtain “substantially all” of the economic benefit from the asset’s use and direct its use throughout the period of the contract.
Summary of what you need to know about ASC 842 (Key Points)
(https://www.hmpc.com/wp-content/uploads/2018/12/HMM_The-New-Lease-Accounting-Standard-2.pdf)
● A lessee is required to recognize all lease contracts – both operating and finance leases – on the balance sheet with the exception of certain short-term leases (less than 12 months).
● Lessor accounting stays mostly consistent with the existing model.
● The standard retains the distinction between finance leases and operating leases, but the required use of bright-line tests that existed under previous GAAP for determining lease classification is eliminated.
● The new standard aims to bring leases onto balance sheets to give investors, lenders, and other financial statement users a more comprehensive view of a company’s long-term financial obligations as well as the assets it actually owns versus leases.
● Until now, companies that report under U.S. GAAP were required to recognize capital leases (finance leases under the new standard) with an asset and liability while operating leases were only disclosed in the notes to the financial statements and not recorded on the balance sheet. Under the new standard, all leases will be recognized on the balance sheet as a right-of-use asset with a corresponding lease liability.
● The new requirement to record operating leases on the balance sheet will have a material impact on certain key financial ratios for some companies, despite the fact that their net assets will remain the same.
● These effects could potentially impact certain agreements, such as debt covenants. Although most financial institutions are aware of the new standard it is recommended that companies begin taking inventory of all leases and calculating the impact on key ratios, then coordinate with any affected counterparties, such as lenders, to address concerns and revise agreements as appropriate.
● Current U.S. GAAP on lease classification is substantially similar in the new lease standard; however, an additional criterion will trigger finance lease classification for assets of a specialized nature with no alternative use to a lessor
● Since all leases will create lease assets and lease liabilities, attention will shift to whether or not arrangements are leases
● Segregating lease and non-lease (e.g. service) components in a lease contract will be a new important process as only lease components will be recognized as lease assets and lease liabilities
● The new lease standard makes a significant change in accounting for related party leases by shifting from substance-based criteria in current U.S. GAAP to accounting for related party leases based on their legally enforceable terms
● Sale/leaseback accounting has substantially changed with the new lease standard; more transactions involving real estate sale/leasebacks will qualify for sale/leaseback accounting due to elimination of continuing involvement rules; however, equipment sale/leasebacks may not qualify for sale/leaseback accounting if the equipment sale/leaseback has a disqualifying repurchase option
● While lessor accounting is substantially unchanged, the accounting for leases with significant variable lease payments could be challenging
Lease Classification
Under the new standard, lessees and lessors will use the following criteria to classify leases at lease commencement. The new criteria focus on whether the contract grants the lessee authority over the underlying asset. If any of the following requirements are satisfied, a lease contract is classified as financing or sales-type leases:
• The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
• The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
• 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.)
• The present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of 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.
Lessee Accounting (https://leasequery.com/blog/asc-842-summary-new-lease-accounting-standards/)
Similar to ASC 840, the new lease accounting standard uses a two-model approach for lessees; each lease is classified as either a finance lease or an operating lease. This applies to all leased asset categories covered under the standard, including leases of equipment and real estate. “Finance lease” is a new term and replaces the term, “capital lease,” used under Topic 840. Additionally, ASC 842 changes the criteria that define a finance/capital lease.
Lessees reporting under Topic 842 are required to recognize both the assets and the liabilities arising from their leases. The lease liability is measured as the present value of lease payments, while the lease asset is equal to the lease liability adjusted for certain items like prepaid rent and lease incentives.
Among the many changes to lease accounting under this standard, the most significant is that operating leases will be recorded on the balance sheet as lease assets and lease liabilities. The asset is known as the right-of-use asset, or (ROU asset), and represents the lessee’s right to use the underlying asset while the lease liability represents the lessee’s financial obligation over the lease term. When measuring the assets and liabilities, both the lessee and the lessor should also include “reasonably certain” lease renewals beyond the current lease term and “reasonably certain” asset purchase options.
For leases with terms of 12 months or less, lessees can elect to not recognize lease assets and liabilities. They should instead recognize lease expense on a straight-line basis, generally, over the term of the lease, similar to the accounting treatment under ASC 840.
Existing capital leases will not require adjustment or remeasurement upon transition, but they will be referred to as finance leases.
Operating lease accounting under ASC 842
When accounting for an operating lease, the lessee must:
● Recognize a single lease cost allocated over the lease term, generally on a straight-line basis
● Classify all cash payments within operating activities on the statement of cash flows
Finance lease accounting under ASC 842
When accounting for finance leases, lessees must:
● Recognize interest on the lease liability and amortization of the right-of-use asset in separate line items of the income statement
● Classify payments of the principal portion of the lease liability within financing activities and payments of interest on the lease liability within operating activities on the statement of cash flows
Lessor lease accounting under ASC 842
Lessor accounting practices remain largely unchanged from ASC 840 to 842. Lessors can classify leases as operating, sales-type, or direct financing leases, but the leveraged lease type under ASC 840 is eliminated under ASC 842. Lessor accounting is covered in full detail in ASC 842-30. No significant changes were made to the requirements for balance sheet recognition.
For operating leases, the leased asset will continue to be recognized as a fixed asset on the lessor’s books, whereas for both sales-type and direct financing leases the lessor derecognizes the leased asset and records a net investment in the lease on the balance sheet. While income from operating leases is recognized on the income statement as rental income, when cash is received from sales-type and direct financing leases a portion is applied as a reduction to the net investment in the lease, and a portion is recognized as interest income.
What can businesses do to prepare for ASC 842?
Transitioning to the new standard can be difficult for both lessees and lessors. Many factors should be considered ahead of the implementation date in order to minimize the impact on your business. Whether you’re in the early stages or have yet to begin, make the most of your time. Here are some preparation actions for the new lease standard:
● Start compiling a list of your leases.
● Prepare for the ASC 842 calculations and disclosures.
● Ensure that accounting staff knows the new standard and can assist in educating anybody in the business who may be in charge of negotiating new leases.
● Evaluate current leases and keep a record of them in a single location.
● Consider service contracts that may have a leasing component or an incorporated lease.
● Quantify the anticipated effects of the new standard on existing leases as of the implementation date.
● Establish systems and controls to gather all data needed to account for leases correctly.
How can we help
HWA Alliance of CPA Firms can help your company effectively implement the new lease accounting standard and maintain compliance after implementation. Our experienced team has the expertise to guide you through the complexity of implementation and advise you on the impact on your financial statements and other critical KPIs.
Furthermore, the new standard’s changes in lease accounting are complicated, and this article overview isn’t designed to address all conceivable complexities. Contact us now to learn more about these accounting standard changes and for assistance with successfully implementing this new lease accounting standard in your organization.