What is Lease Accounting?
The lease accounting standards define how companies must account for their leases – a specific type of contract that allows one party to use an asset of another party in exchange for consideration. Leases may be for equipment or real estate and are classified as either operating or capital leases. However, a new lease accounting standard has been introduced that will change how companies account for leases.
What is ASC 842?
Accounting Standards Codification Topic 842, also known as ASC 842 and as ASU 2016-02, is the new lease accounting standard. It was published by the Financial Accounting Standards Board (FASB) in February 2016. ASC 842 replaces FASB’s ASC 840 standard for US GAAP, which is almost 40 years old.
What Does ASC 842 Change?
ASC 842 represents a significant overhaul of the accounting treatment for leases, with the most significant change being that most leases, including most operating leases, will now be capitalized on the balance sheet. Under ASC 840, FASB permitted operating leases to be reported only in the footnotes of corporate financial statements. Under ASC 842, the only leases that are exempt from the capitalization requirement are short-term leases less than or equal to 12 months in length.
The goal of the changes is to provide users of financial statements, such as lenders and retail and institutional investors, with increased visibility into the leasing obligations of companies.
Businesses will begin transitioning to ASC 842 for accounting periods starting on or after January 1st, 2019. The first wave will consist largely of public companies, with private companies and other entities adopting in 2020.
Impacts to Financial Statements
ASC 842 Impact to the Balance Sheet
Under the current US GAAP rules, leases are classified as either capital leases or operating leases. While capital leases are recorded on a company’s balance sheet, the operating leases are not. The new ASC 842 standard changes the types of classifications and the balance sheet treatment. Going forward under the new standards, both classifications of leases, operating and finance, will be on the balance sheet. There are a few exceptions, such as certain short-term leases less than or equal to 12 months in duration. However, in most cases a right-of-use (ROU) asset will be recognized on the balance sheet along with a corresponding liability for the lease obligation.
ASC 842 Impact to the Income Statement
The treatment of operating and finance leases will differ on the income statement under the new ASC 842 standard. For finance leases, the interest and amortization of the lease are presented separately on the income statement. However, for operating leases, the two are combined into a single line-item. With operating leases, a straight-line expense profile typically results. With finance leases, the expense profile is typically front-loaded due to the separate interest on the lease liability.
Lease Accounting Terminology
What are Right-of-Use Assets?
ASC 842 requires that most operating leases be capitalized on the balance sheet as a right-of-use asset and lease liability. The term right-of-use asset is used to define whether or not the lessee has the right to use the asset over the term of the lease. If the lessee does not have the right to use the asset, then the contract does not actually contain a lease.
Two criteria must be met for there to be a right-of-use asset in the contract. First, there must be an identified asset in the contract. Second, the lessee must receive substantially all of the economic benefit from using the asset and the right to direct the use of the asset throughout the lease term.
The right-of-use asset is valued as the initial amount of the lease liability plus any initial direct costs and lease payments made prior to the commencement date, and minus lease incentives.
What are Lease Liabilities?
The lease liability is calculated as the present value of the lease payments. When calculating the present value, the standard specifies lessees should use the discount rate specified in the lease, or if that is not available, the company’s incremental borrowing rate (IBR).
The lease classification tool tests how your leases will be classified under ASC 842.