Let’s Start From the Beginning: What is ASC 842?
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. ASC 842, or Topic 842, is the new lease accounting standard issued by the FASB to replace ASC 40.
Among other changes, it requires all public and private entities reporting under US GAAP to record the vast majority of their leases to the balance sheet.
The new standard supersedes ASC 840 and has gone into effect for public companies. Private entities with fiscal years beginning after Dec 15, 2018, and Dec 15, 2021, respectively are required to ensure they are compliant by year-end.
The goal of the new standard is to:
- Make lease accounting under US GAAP more efficient
- Improve transparency into liabilities resulting from leasing arrangement
- Decrease off-balance-sheet activities
Why was ASC 840 replaced with ASC 842?
Under ASC 840, only a limited number of leases were recorded on the balance sheet. For example, an operating lease was always an off-balance-sheet transaction. This could pose a real lack of transparency since the payment obligations for an operating lease should be clearly presented so users of financial statements can assess the amount, timing, and uncertainty of cash flows arising from leases.
Due to this, ASC 842 has been designed to
- Improve financial reporting
- Increase transparency
- Comparability across organizations
A good example is airline companies. Airline companies that buy and own planes carry heavy debt on their balance sheets, but airlines that lease their planes may have misleadingly-clean balance sheets despite having materially-similar lease obligations.
ASC 842 effective dates
Public and private companies have different effective dates for the new lease accounting standard.
For public companies, the FASB standard was effective for reporting periods that began subsequent to December 15, 2018. For calendar year-end companies, this means the standard was adopted on January 1, 2019.
65% of Public Companies admitted that their transition was far more complicated than they expected
For private companies and nonprofit organizations’ annual reporting periods beginning after December 15, 2021.
Meaning that starting this year, December 2022, all private and nonprofit organizations must comply to avoid penalties.
What’s covered and what’s not?
As with most things, exceptions do exist. There are some cases in which a contract may contain a lease, but it’s not in the scope of ASC 842.
Below are the out-of-scope lease types:
- Leases of intangible assets, i.e. cloud computing agreements.
- ASC 930: Leases for the exploration or use of non-regenerative natural resources such as oil, natural gas, and minerals.
- ASC 905: Leases of biological assets such as plants, animals, and timber.
- ASC 330: Leases of inventory.
- ASC 360: Leases of assets that are under construction.
In Scope Lease types:
ASC 842 is made up of 5 subtopics:
- Lessee accounting for operating leases and finance leases
- Lessor accounting
- Sale-leaseback transactions
- Leveraged lease arrangements
Lessee accounting under ASC 842
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: “finance lease” is a new term and replaces the term, “capital lease,” used under Topic 840. Under a Finance Lease, 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
- An operating lease. One of the most important changes is that operating leases will be recorded on the balance sheet as lease assets and lease liabilities. Under an Operating Lease, lessees 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
In addition to changing from a capital lease to a finance lease, 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 leased asset is equal to the lease liability adjusted for certain items like prepaid rent and lease incentives.
- For leases with terms of 12 months or less, lessees can elect to not recognize lease assets and liabilities. They should instead recognize lease expenses on a straight-line basis, generally, over the term of the lease, similar to the accounting treatment under ASC 840.
- Right-of-use asset (ROU asset) 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.
- Existing capital leases will not require adjustment or remeasurement upon transition, but they will be referred to as finance leases.
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.
ASC 842 disclosure requirements
The disclosure requirements for FASB 842 are both qualitative and quantitative. A few of the specific disclosures required are:
- Discussions covering the lease arrangements
- Descriptions of significant judgments made
- Details about the lease costs reported on the income statement
- Weighted-average analysis of discount rates and remaining lease terms
We provide a full overview of the disclosure requirements of ASC 842 with examples in our article, “ASC 842 Disclosure Requirements: Example and Explanation.”
The Clock is Ticking: Private companies should be ready to transition
The transition to the new standard can be challenging for lessees. Make sure you’re prepared with the ASC 842 Adoption Kit.
Within this kit, we provide tools and resources to help navigate the transition. [Partner to insert contact info and additional CTAs, etc.]