ASC 842 is a new accounting standard that defines how businesses record the financial impact of their lease agreements. Since its introduction, all public and private entities reporting under US GAAP should report the majority of their leases on the balance sheet. This new standard aims to increase transparency into liabilities resulting from leasing arrangements and reduce off-balance sheet activities.
Let’s try and break down ASC 842 lease accounting.
Key takeaways
- ASC 842, introduced by the Financial Accounting Standards Board (FASB), changes lease accounting, emphasizing transparency and comparability in financial reporting related to leases. By requiring companies to recognize most leases on their balance sheets, ASC 842 ensures stakeholders have a clearer picture of a company’s financial obligations and assets.
- ASC 842 significantly impacts financial statements and ratios. It brings most leases onto the balance sheet, affecting total assets, liabilities, and equity. Moreover, while ASC 842 doesn’t directly impact net income, it changes how lease expenses are categorized, potentially affecting operating income and cash flow classifications.
- Adding ASC 842 can be challenging for companies due to data collection, system implementation, and lease identification. To ensure compliance, they can establish cross-functional teams, invest in lease accounting software, conduct comprehensive lease reviews, provide ongoing training, and implement robust controls.
What is lease accounting under ASC 842?
Lease accounting has always been an important part of financial reporting, but it hasn’t always been clear and consistent. With the introduction of ASC 842, things have changed. ASC 842, or Accounting Standards Codification 842, is a set of rules created by the Financial Accounting Standards Board (FASB) to improve how companies report leases in their financial statements.
Let’s take a quick look at ASC 842 lease accounting.
So, what does lease accounting mean?
In a nutshell, lease accounting involves recording and reporting lease transactions in a company’s financial statements. It encompasses the rules and principles that govern how leases are recognized, measured, and disclosed in financial reports. The primary objective of lease accounting is to accurately reflect a company’s financial position, performance, and cash flows related to leasing activities.
Here are the basic steps it comprises.
- Lease classification involves determining which category your leases belong to based on the transfer of ownership, the lease term, and the present value of lease payments.
- Recognition in the financial statements. Leases can be reported as both assets and liabilities in a balance sheet, as they denote the right to use the leased item and the obligation to make lease payments.
- Measurement of the lease liability and the right-of-use asset is the next step. You calculate the lease liability as the current value of lease payments. Similarly, the right-of-use asset is initially calculated at the same amount as the lease liability, with adjustments made for initial direct costs, prepaid/accrued lease payments, and any incentives received from the lessor.
- Subsequent accounting involves recognizing interest expense on the lease liability and depreciating the right-of-use asset over the lease term. For lessors, they recognize lease income over the lease term.
- Disclosure in the financial statements includes mentioning details about lease terms, lease payments, significant judgments and assumptions, and the nature of leased assets.
What is ASC 842?
ASC 842, or Accounting Standards Codification 842, is a set of accounting rules issued by the Financial Accounting Standards Board (FASB) that govern how companies should account for leases in their financial statements. It represents a significant change in lease accounting standards, aiming to improve transparency and comparability in financial reporting related to leases.
ASC 842 introduces new criteria for determining lease classification. It also imposes enhanced disclosure requirements to provide users of financial statements with comprehensive information about lease arrangements.
In other words, ASC 842 is all about making lease accounting more transparent and comparable across different companies.
Before ASC 842, some leases, called operating leases, weren’t always shown on a company’s balance sheet. This made it hard for people looking at financial statements to understand how much a company owed for these leases. ASC 842 changes that by requiring companies to show most leases on their balance sheets.
The main goal of ASC 842 is to make it easier for investors, lenders, and others to understand a company’s financial situation. By having most leases on the balance sheet, people can see a clearer picture of what a company owes and owns. This helps everyone make better decisions.
Now, let’s look at it in a bit more detail.
What are the key changes from previous lease accounting standards?
The shift from the previous lease accounting standard, ASC 840, to ASC 842 significantly changes how companies account for leases in their financial statements.
Let’s look at the differences between these standards and explore the impact of ASC 842 on financial reporting and financial ratios.
Differences between ASC 840 and ASC 842
Differences between these two standards comprise various aspects of handling lease agreements in financial statements, such as their presentation, classification, and certain requirements. Let’s break them down.
Difference #1 – Balance sheet presentation
One of the most significant changes introduced by ASC 842 is the treatment of leases on the balance sheet.
Under ASC 840, companies often kept operating leases off the balance sheet. It could obscure the true extent of lease obligations. In contrast, ASC 842 requires lessees to recognize most leases, including operating leases, on the balance sheet as both a right-of-use asset and a lease liability. This change enhances transparency about a company’s financial position.
Difference #2 – Lease classification
ASC 842 introduces a more principles-based approach to lease classification compared to the rules-based approach of ASC 840.
It emphasizes the evaluation of control, transfer of ownership, and economic substance of lease agreements to determine whether a lease is a finance lease or an operating lease. This change in classification criteria may result in different lease classifications compared to ASC 840.
Difference #3 – Disclosure requirements
ASC 842 imposes more extensive disclosure requirements compared to ASC 840. Companies should provide additional information about lease arrangements, lease terms, significant judgments and assumptions, and the nature of leased assets. This increased transparency aims to help users of financial statements better understand a company’s leasing activities and financial obligations.
Impact of ASC 842 on financial statements and financial ratios
The implementation of ASC 842 has several implications for financial reporting and financial ratios.
#1 – Impact on the balance sheet
ASC 842 brings most leases onto the balance sheet, significantly affecting key balance sheet metrics such as total assets, total liabilities, and equity. The recognition of lease liabilities increases reported liabilities, while the recognition of right-of-use assets increases reported assets. As a result, companies may experience changes in their debt-to-equity ratios and leverage ratios.
#2 – Changes to the income statement
While ASC 842 does not directly impact net income, it may affect income statement metrics, such as operating expenses and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). The classification of lease payments as interest and depreciation expenses may result in changes to operating expenses and operating income.
#3 – Cash flow implications
ASC 842 does not affect total cash flows, but it may impact the classification of cash flows in the statement of cash flows. Lease payments classified as operating activities under ASC 840 may be reclassified as financing activities and operating activities under ASC 842, depending on the nature of the lease.
As you can see, there’s quite a shift in lease accounting standards, emphasizing transparency, comparability, and accuracy in financial reporting. As a business, you might want to carefully evaluate these differences, as they can help enhance the transparency and reliability of your financial reporting for stakeholders.
How do you account for leases under ASC 842?
As mentioned, lease classification and lease recognition are critical aspects of lease accounting. With the introduction of ASC 842, these aspects require your special attention.
Let’s break down these terms and how they apply to businesses.
Lease classification – finance leases vs. operating leases
Leases in accounting typically fall into two main categories: finance leases and operating leases. The classification depends on the nature of the lease agreement and the extent of control over the leased asset.
#1 – Finance leases
Finance leases are similar to owning a leased asset. The lessee (the one who rents the asset) has significant control over the use of the asset throughout most of its economic life. Finance leases usually involve long-term agreements and transfer substantially all the risks and rewards of ownership to the lessee.
Examples include equipment leases where the lessee bears the maintenance costs and can purchase the equipment at the end of the lease term.
#2 – Operating leases
Operating leases, on the other hand, are more like renting. The lessee doesn’t have the same level of control or risks associated with ownership. These leases are often shorter-term agreements for assets like office space or vehicles. Operating leases typically do not transfer ownership rights to the lessee at the end of the lease term.
To determine the classification of a lease under ASC 842, companies evaluate specific criteria outlined in the standard, such as the transfer of ownership, the lease term, and the present value of lease payments.
Recognition and measurement for lessees and lessors
Once a lease is classified, ASC 842 sets out recognition and measurement requirements for lessees and lessors.
#1 – Requirements for lessees
Lessees – those who rent assets – should recognize lease assets and lease liabilities on their balance sheets for both finance leases and operating leases.
As mentioned, the lease liability represents the obligation to make lease payments. The lease asset represents the right to use the leased asset during the lease term.
The initial measurement of the lease liability is based on the present value of lease payments. The lease asset is measured at the same amount as the lease liability, adjusted for initial direct costs, prepaid or accrued lease payments, and incentives received from the lessor.
#2 – Requirements for lessors
Lessors, the ones who own the leased asset, follow slightly different recognition and measurement requirements.
For finance leases, lessors recognize a lease receivable and a deferred selling profit or loss at the commencement of the lease. For operating leases, lessors continue to recognize the underlying asset and lease income over the lease term.
Understanding disclosures required under ASC 842
ASC 842 also introduces some disclosure requirements for lessees and lessors. Let’s explore the specifics of these disclosure requirements and their importance in enhancing transparency in financial reporting.
#1 – ASC 842 disclosure requirements for lessees
Lessees must share both qualitative and quantitative information about their leasing arrangements.
Qualitative information includes a general description of their leasing activities and policies for recognizing and measuring leases.
For quantitative disclosures, lessees must disclose the amount of lease liabilities recognized on the balance sheet, the weighted average remaining lease term, and the weighted average discount rate used to determine lease liabilities.
Lessees must also provide information about significant judgments and assumptions used in determining lease terms, including discount rates, lease terms, and impairment assessments.
#2 – ASC 842 disclosure requirements for lessors
Lessors also should disclose qualitative and quantitative information about their leasing activities. It includes a detailed description of significant leasing arrangements and policies for measuring and recognizing lease income.
In terms of quantitative disclosures, lessors must report the amount of lease income recognized during the reporting period, along with a maturity analysis of lease receivables.
Additionally, lessors must provide information about significant judgments and assumptions used in determining lease income, such as lease classification and collectibility assessments.
The rationale behind disclosure requirements
The disclosure requirements under ASC 842 serve several important purposes. Let’s look at them real quick.
- Enhancing transparency
Having detailed information about leasing activities, including lease liabilities, lease assets, and lease income, helps companies maintain transparency in financial reporting. This way, stakeholders can better understand the nature and extent of a company’s leasing arrangements. - Facilitating comparability
Standardized disclosure requirements enable users of financial statements to compare leasing activities across different companies. Consistent and comprehensive disclosures facilitate more meaningful analysis and decision-making. - Improving risk assessment
Disclosure of significant judgments and assumptions used in lease accounting enables stakeholders to assess the reliability and reasonableness of lease-related estimates. Investors and creditors, at this point, can evaluate the company’s financial health and risk profile. - Promoting accountability
Transparent disclosure of leasing activities promotes accountability and corporate governance. Companies are accountable to their stakeholders for the accuracy and completeness of financial reporting, including disclosures related to leases.
How does ASC 842 impact financial statement analysis?
Summing up the above, ASC 842 implementation affects financial statement analysis in many ways. New rules require companies to show lease assets and liabilities on their balance sheet, impacting metrics such as total assets, liabilities, and equity. While ASC 842 doesn’t impact net income, it changes lease expense classification, potentially affecting operating income and EBITDA. Reclassified lease payments under ASC 842 may affect cash flow statement classification, requiring adjustments for analyzing operating cash flows and financing activities. This complexity in lease accounting under ASC 842 echoes the intricacies faced during the implementation of revenue recognition standards like ASC 606 and IFRS 15.
Analysts must evaluate these implications for a company’s leverage and financial health. Here’s how they can do it.
Balance sheet analysis
Stakeholders should carefully analyze the balance sheet to understand the impact of recognized lease assets and liabilities. They should assess how these changes affect financial metrics such as total assets, liabilities, and equity. For instance, increased lease liabilities may indicate higher financial leverage, while higher lease assets could suggest increased capital intensity.
Income statement analysis
ASC 842 also alters the recognition of lease expenses in the income statement. Previously, they might have come within operating expenses. However, under ASC 842, these expenses may now be categorized as interest and depreciation expenses. These changes might impact operating expenses, operating income, and overall profitability overview.
Cash flow statement analysis
ASC 842 affects the classification of lease payments in the cash flow statement. Once considered operating activities, now they might be classified as financing activities or a combination of operating and financing activities. Stakeholders should review the cash flow statement to understand how lease payments impact operating cash flows and financing activities. For instance, a company with significant lease payments may experience changes in its cash flow patterns and capital allocation strategies.
What are the practical challenges in implementing ASC 842?
As companies transition to ASC 842, they might encounter several challenges that can complicate the adoption process. From data collection hurdles to system implementation complexities and lease identification struggles, these challenges can impede smooth compliance with the new standard. Leveraging enterprise accounting software can mitigate some of these challenges by streamlining data collection and analysis.
Let’s look at these challenges and explore best practices for overcoming them.
Common challenges in adopting ASC 842
- Data collection
One of the primary challenges companies face is gathering comprehensive lease data. This includes lease agreements, terms, payment schedules, and other relevant information spread across various departments and locations. Incomplete or inaccurate lease data can hinder the accurate implementation of ASC 842.
- System implementation
Adopting ASC 842 requires companies to update or implement new accounting systems capable of handling the complexities of lease accounting under the new standard. System integration, customization, and testing can pose significant challenges, especially for organizations with legacy systems or decentralized operations.
- Lease identification
Identifying and categorizing leases is crucial for ASC 842 compliance. Companies must distinguish between finance leases and operating leases based on complex criteria outlined in the standard. Lease identification errors can result in misclassification and inaccurate financial reporting.
Best practices for lease accounting
Now, let’s look at some recommendations that might help your lease accounting initiatives and adoption of the ASC 842 requirements.
#1 – Establish cross-functional teams
Forming cross-functional teams comprising representatives from finance, accounting, legal, and IT departments can facilitate effective collaboration and communication throughout the adoption process. These teams can oversee data collection efforts, system implementation, and lease identification activities.
#2 – Invest in lease accounting software
Investing in specialized lease accounting software can streamline lease data management and automate lease calculations, reducing manual errors and enhancing efficiency. Look for software solutions that offer robust lease administration, lease accounting, and reporting capabilities tailored to ASC 842 requirements.
#3 – Conduct comprehensive lease reviews
Conduct thorough reviews of existing lease agreements to ensure completeness and accuracy of lease data. Engage with key stakeholders, including landlords and leasing partners, to clarify lease terms and resolve discrepancies. Consider engaging external consultants or auditors for independent lease reviews and validation.
#4 – Provide ongoing training
Offer comprehensive training and education programs to finance and accounting teams to familiarize them with ASC 842 requirements and processes. Ensure staff members understand lease accounting principles, lease classification criteria, and disclosure requirements to promote accurate and consistent standard application.
#4 – Implement robust controls and monitoring mechanisms
Establish robust internal controls and monitoring mechanisms to detect and address potential errors or inconsistencies in lease accounting processes. Implement regular reviews and reconciliations of lease data to identify anomalies and ensure compliance with ASC 842.
What are the journal entries for ASC 842?
ASC 842 introduces specific journal entries for lessees and lessors, including initial recognition, subsequent measurement, and lease payment entries. This detailed approach to accounting entries is akin to what businesses had to adapt to under the revenue recognition ASC 606 guidelines. Additionally, it outlines the accounting treatment for lease modifications, reassessments, and terminations, ensuring accurate and transparent lease accounting practices in compliance with the new standard.
Journal entries for lessees and lessors under ASC 842
Let’s go through the lease accounting process to see how journal entries under ASC 842 apply there.
Initial recognition
- Upon initial recognition of a lease, a lessee records a right-of-use asset and a lease liability on the balance sheet. The journal entry debits the right-of-use asset and credits the lease liability.
- For lessors, upon initial recognition, a lessor records a lease receivable and a deferred lease income (unearned revenue) on the balance sheet. The journal entry debits the lease receivable and credits the deferred lease income.
Subsequent measurement
- After initial recognition, lessees must adjust the carrying amount of the lease liability for interest expense and reduce the right-of-use asset for depreciation expense. The journal entry for lease expense debits interest expense, debits depreciation expense, and credits cash.
- For lessors, subsequent measurement involves recognizing lease income over the lease term. The journal entry for lease income debits cash or accounts receivable and credits lease income.
Lease payment entries
- When making lease payments, lessees record a reduction in the lease liability and a cash outflow. The journal entry debits the lease liability and credits cash.
- Upon receiving lease payments, lessors record an increase in cash or accounts receivable and a decrease in the lease receivable. The journal entry debits cash or accounts receivable and credits the lease receivable.
Accounting treatment for lease modifications, reassessments, and terminations under ASC 842
Now, to the accounting treatment for lease modifications, reassessments, and terminations.
Lease modifications
When a lease modification occurs, lessees and lessors must assess whether the modification results in a new lease or a change to the existing lease. Adjustments to lease payments or lease terms require a reassessment of lease classification and accounting treatment.
Reassessments
ASC 842 requires lessees to reassess lease terms and terminations under ASC 842. Certain events, such as changes in lease terms, modifications, or changes in the economic environment, may necessitate a reassessment of lease classification and accounting treatment.
Terminations
When leases are terminated before the end of the lease term, lessees must recognize any remaining lease liability and adjust the right-of-use asset accordingly. Lessors need to derecognize the lease receivable and adjust the deferred lease income.
Bottom line
Let’s make the long story short.
The adoption of ASC 842 marks a significant shift in lease accounting standards, driven by the need for increased transparency and comparability in financial reporting. By requiring companies to recognize most leases on their balance sheets, ASC 842 ensures stakeholders have a clearer understanding of a company’s financial position and obligations.
This change also impacts financial statements and ratios, prompting stakeholders to reassess how they analyze and interpret financial data. Despite the practical challenges associated with implementing ASC 842, companies can navigate this transition successfully by leveraging cross-functional teams, investing in technology, conducting thorough lease reviews, providing ongoing training, and implementing robust controls.
The introduction of changes into accounting standards might require some catch up bookkeeping, especially if you’ve been neglecting it for some time. And a common recommendation is to consult with a professional accountant to help you smoothly adopt the ASC 842 changes.
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