- ASC 842 & IFRS 16: Joint effort to develop the new lease accounting standards
- Summary of changes: Why was ASC 840 replaced with ASC 842?
- Lessee accounting for finance and operating leases
- Lessor accounting
- Sale-leaseback accounting
- Leveraged lease accounting
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.
In February 2016, the FASB issued ASU 2016-02, or Accounting Standards Update 2016-02. This update provided the much-anticipated new guidance for lease accounting through the release of ASC 842, a new section of the accounting standards codification ultimately superseding ASC 840. Topic 842 would be updated several more times in the years to come, but ASU 2016-02 provided accountants with their first look at the new guidance on leases applicable to both public and private companies in the coming years. It also contained the first information on when businesses would be required to adopt the new standard.
ASC 842 and IFRS 16 Leases (IFRS 16, also released in January 2016) were initially developed as part of a joint effort between the FASB and the International Accounting Standards Board (IASB). As the accounting profession continued to promote greater transparency for financial statement stakeholders, both of the new standards required the majority of leases to be recorded on the balance sheet.
ASC 842 vs. IFRS 16: Major differences emerge
Despite the Boards’ efforts to streamline lease accounting with the introduction of these new standards, some major differences between the two standards emerged. For example, while ASC 842 continues to distinguish between finance and operating leases, both are now required to be recorded on the balance sheet. Alternatively, IFRS 16 removes the operating lease classification and requires that all lessee leases be treated as finance leases.
More examples of how IFRS 16 differs from ASC 842
- Under IFRS 16, the lease liability is remeasured each time the reference index or a rate variable lease payments are tied to are reset, whereas ASC 842 does not require the lease liability to be remeasured when indices or rates are reset.
- Though FASB Topic 842 does not explicitly exclude immaterial leases or low-value assets, these are exempt from balance sheet recognition under IFRS 16. The Basis for Conclusions paragraph 100 to IFRS 16 addresses how companies can define “low value” assets and offers $5,000 for consideration.
- FASB Topic 842 permits private companies to use a risk-free rate to calculate the lease liability, but IFRS 16 does not provide guidance specific to private entities.
- While FASB Topic 842 generally requires interest payments to be included within operating activities on the statement of cash flows, IFRS 16 allows interest to be reported within operating, investing, or financing activities.
For more examples of differences covered in full detail, read our blog, “IFRS 16 vs. US GAAP Lease Accounting: What Are the Differences?”
Under ASC 840, only a limited number of leases were recorded on the balance sheet. An operating lease, for instance, was always an off-balance-sheet transaction. However, the payment obligations for an operating lease represent a real liability and should be clearly presented so users of financial statements can assess the amount, timing, and uncertainty of cash flows arising from leases.
Given the widespread prevalence of off-balance-sheet leasing activities, the new lease accounting rules are intended to improve financial reporting and increase transparency and comparability across organizations. This new guidance will also require organizations to disclose vital information about leasing arrangements to investors. For instance, airlines 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.
Implementing the new guidance will also provide management better insight into the true extent of their lease obligations and lead to improvements in capital allocation, capital budgeting, and lease vs. buy decisions.
Effective date of ASC 842 for public companies
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.
Effective date of ASC 842 for private companies
ASC 842 is effective for private companies’ and nonprofit organizations’ annual reporting periods beginning after December 15, 2021. This means many private companies and non-profit organizations are working through the lease accounting transition right now.
ASC 842 applies to most leases and subleases, but exceptions do exist. There are some cases in which a contract contains a lease, but it’s out of the scope of Topic 842 and the guidance should not be applied to the transaction. Here are the out of scope lease types, as detailed in Subtopic 842-10-15-1:
- Leases of intangible assets, such as cloud computing arrangements. The guidance for these agreements can be found in ASC 350, Intangibles – Goodwill and Other.
- Leases for the exploration or use of non-regenerative natural resources such as oil, natural gas, and minerals are covered under ASC 930, Extractive Activities – Mining, and ASC 932, Extractive Activities – Oil and Gas.
- Leases of biological assets such as plants, animals, and timber. These are addressed in ASC 905, Agriculture.
- Leases of inventory, which are covered under ASC 330, Inventory.
- Leases of assets that are under construction. These are addressed in ASC 360, Property, Plant, and Equipment.
ASC 842 is made up of five subtopics – an overview and four sections covering the following transaction types:
- Lessee accounting for operating leases and finance leases
- Lessor accounting
- Sale-leaseback transactions
- Leveraged lease arrangements
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
Operating lease accounting examples under ASC 842
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
Finance lease accounting examples 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.
Read more about accounting for lessors in our blog, “Lessor vs. Lessee Accounting Explained: FASB, IFRS, and GASB.”
In a sale-leaseback transaction, the lessee sells the asset to the buyer/lessor and enters into an agreement to lease the asset back from the buyer/lessor. This type of transaction consists of both a sale and a lease. The determination of whether or not the transaction is a sale is performed in accordance with ASC 606, Revenue from Contracts with Customers. ASC 606 was released in 2014 and is the current standard for revenue recognition under US GAAP.
As a result of the changes under both ASC 606 and ASC 842, some transactions not qualified for sale and leaseback accounting under ASC 840 will qualify under ASC 842. The opposite is also true: some sale-leaseback transactions under ASC 840 will no longer qualify for this accounting under ASC 842. However, transactions correctly accounted for using sale-leaseback accounting under ASC 840 do not have to be reassessed during the transition to ASC 842.
For a full example of a sale-leaseback transaction, read our blog, “Sale-leaseback Accounting under ASC 606 and ASC 842 Explained.”
Under Topic 840, a leveraged lease was defined as an agreement in which the lessor borrows funds from a lender to help pay for the purchase of an asset that is then leased to a lessee. The lender holds the title of the asset and the lease payments made by the lessee are collected by the lessor. The lessor is then responsible for sending payments to the lender.
As we mentioned above, ASC 842 essentially eliminates the leveraged lease classification. Lessors can only classify a lease arrangement as a leveraged lease if the commencement date is prior to the effective date of the new lease accounting standard. For private companies that haven’t yet adopted ASC 842, the accounting for leveraged leases under ASC 840 will continue to apply to all leases that meet the criteria. The accounting is detailed in ASC 842-50.
Ultimately, this means no new leveraged leases will be created following the final effective date of the new standard. Leases with a commencement date falling after an entity’s effective date for ASC 842 should be accounted for in accordance with the rules for lessor accounting (covered earlier in this article) and contained in ASC 842-30.
Topic 842 offers elections meant to ease the transition process, referred to as practical expedients. Some of the practical expedients under ASC 842 include grandfathering of lease classification, combining lease and non-lease components, and not restating the prior year’s financials.
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 transition to the new standard can be challenging for lessees. In a survey we conducted with companies in the process of adoption, we found that 50% of respondents in the early stages of transition anticipated it to be neither easy nor difficult. Companies who are further along in the transition process, however, have a different opinion; 67% percent found it to be difficult. This may be due in part to the number of steps required to transition, listed below. Whether you’re in the early stages or you’ve yet to start, make sure to use your time wisely.
*Note: For a full operating lease transition example under ASC 842 with journal entries, read “Operating Lease Accounting under the New Standard, ASC 842: Full Example and Explanation.”
1. Start building an inventory of your leases
Completeness of your lease inventory is crucial for compliance. We provide guidance on how to develop a comprehensive lease inventory in this blog. To summarize, you’ll need to work with multiple departments across the company. Look at your requisitions process first to determine which departments have contracts funneled through them. Next, document each lease and its pertinent details in a single place, such as an internally-developed template. This may be an organizational cultural shift – taking something most companies do in a decentralized manner and moving toward a centralized process.
2. Begin gathering your embedded leases
As part of your lease inventorying process, you’ll also need to compile your embedded leases, or leases that exist within other contracts like service agreements. Your existing service contracts may need to be reassessed.
ASC 842 provides a practical expedient allowing you to not re-evaluate expired or existing contracts. However, this assumes no errors were made in the original assessment. To confirm no errors exist, you may still need to reassess your contracts.
If you’re struggling with determining the population of your embedded leases, you’re not alone. Many companies are overwhelmed by this process. Some common types of contracts containing embedded leases are listed below as a starting point:
- Security contracts often contain leases for equipment, such as scanners or monitors
- Logistics and transportation agreements may contain language identifying a specific vehicle to be used solely for your needs
- Datacenter contracts may designate specific servers for your company
To help you identify your embedded leases, we offer a free interactive embedded lease test to use in determining if your contracts contain embedded leases:
3. Prepare for the calculations and disclosures needed under ASC 842
The disclosure requirements under ASC 842 are much more robust than those required under ASC 840. To be compliant, a series of complex calculations will need to be undertaken each reporting period. Beyond calculating the initial lease liability and right-of-use asset discussed above, you may also need to calculate:
- Lease liability amortization schedule
- Right-of-use asset amortization schedule
- Operating lease cost – straight-line rent expense
- Finance lease cost – interest expense and ROU asset amortization
- Weighted average discount rates for operating and finance leases
- Weighted average lease term for operating and finance leases
- Maturity analysis of lease liabilities segregated between operating and finance leases
- Incremental borrowing rate
- Discount rate implicit in the lease
4. Start evaluating software
Lease accounting software will save you an immense amount of time, but it does take some upfront work to get the solution up and running. If you’re weighing whether to wait or to start assessing software options now, consider the benefits of implementing early:
- Ensures correct accounting under ASC 840 for a seamless transition
- Allows more time to thoroughly evaluate your options and find the best fit for your organization
- Reduces stress during the implementation process
- Promotes comfort and confidence in using the software well before the first post-transition journal entries and reports are run
- Provides a centralized location to store all collected lease documentation
- Creates benefits for departments outside of accounting, such as improved access to lease contracts and facilitates intradepartmental communication
There are numerous benefits to implementing an accounting system like LeaseQuery. Here are a few:
1. Find more opportunities to reduce costs
One crucial feature is getting alerts for critical dates related to your leases, such as reminders about renewals or termination notice periods. These alerts help save money and ensure that you don’t miss any chances to renew important leases or terminate unneeded ones.
2. Improvements to accounting accuracy and reduction of errors
Many companies are still using Excel for lease accounting instead of using an accounting-focused software solution. Excel is more manual, takes more of the accounting team’s time away from analysis, and often leaves companies with doubts about the accuracy of their calculations.
Some companies even have horror stories about using Excel for leases. For example, using Excel for tracking leases resulted in a $648,000 overpayment of rent for one customer prior to their LeaseQuery implementation. The inability to set up an alert to notify the accounting department when periodic rent should have been abated on every anniversary of the lease led to a steep unnecessary payment.
Another company lost a tenant improvement allowance worth over $2 million after they realized, during the acquisition process, the TIA was not transferred. Excel had nowhere to capture the information.
3. Improved budgeting and forecasting
The right software can provide the ability to budget or forecast the income statement, balance sheet, and cash flow impacts from lease accounting at transition as well as in a steady state. Budgeting and forecasting functionality allows you to identify how much cash you’ll spend in a given period as well as how much will be spent by a particular region, department, or business division. Your solution’s out-of-the-box forecasting reports should be able to help determine the impact your lease portfolio has on important reporting metrics, such as earnings per share and EBITDA. Using anything other than lease accounting software to calculate the above would require quite a bit of extra effort.
Finding a lease accounting solution that has custom reporting features is also important so you can create a report specifically for your organization’s needs. That way, you’ll be an expert when colleagues request information about leases and their financial impact to the company.