Lease Accounting

What is ASC 842?

Overview

ASC 842, also called ASU 2016-02, is the new lease accounting standard published by the Financial Accounting Standards Board (FASB). It was issued on February 25, 2016 and will replace the previous FASB lease accounting standard, ASC 840. It applies to filers who report under US Generally Accepted Accounting Principles (US GAAP). Public companies must implement the standard for the first fiscal year beginning after December 15, 2018. Private companies follow a year later on December 15, 2019.

ASC 842 is the result of a collaboration between the FASB and the International Accounting Standards Board (IASB). The purpose of the new standard to close a major accounting loophole in ASC 840: off-balance sheet operating leases.

Major Changes from ASC 840

Under ASC 840, corporations can report operating leases in the footnotes of financial statements as “off-balance sheet leases,” rather than on the balance sheet as assets and liabilities. After the accounting scandals of the early 2000s, the SEC was concerned that this method could hurt smaller investors. They do not have the resources to dig through financial statements, so face decreased transparency into a corporation’s true liabilities.

In response, after a decade of work writing and reviewing exposure drafts, the FASB released ASC 842. ASC 842 closes the ASC 840 loophole by requiring that all operating leases be capitalized on the balance sheet.

Lease Definition

The definition of a lease has also slightly changed. Under ASC 842, “[a] contract is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. ”

To qualify as right-of-use, the contract must meet the following criteria:

  1. There is an identified asset: An asset can only be identified if it is physically distinct or if the lessee receives substantially all of the capacity of the asset. In addition, the lessor cannot have substantive rights to substitute the asset.
  2. The lessee receives substantially all of the economic benefit: First, the parties must define the economic benefits of the asset. Then, they must determine the allocation of economic benefits.
  3. The lessee has the right to direct the use of the asset:The lessee has the right to direct the use of the asset. In a case where how the asset is used is predetermined, the lessee must have the right to operate the asset or had designed it in a way that predetermines how it will be used.

Lease Classification

ASC 842 will still classify leases into finance leases (capital leases under ASC 840) and operating leases.

For a lease to be defined as a finance lease, it can meet any of the following criteria:

  • The underlying asset transfers ownership to the lessee at the end of term
  • There is an option to purchase the underlying asset that is likely to be exercised
  • The lease term is for the major part of the remaining economic life of the asset
  • The present value of lease payments plus any guaranteed residual value is greater than or equal to substantially all of the fair market value of the asset
  • The asset is specialized to the extent that it is only useful to the lessee

Short-term leases – a term less than or equal to 12 months – do not have to be reported on balance sheet.

Impacts to Financial Statements

The transition to ASC 842 could impact corporate financial statements.

  • Balance Sheet: For every operating lease, a right-of-use asset and lease liability will be capitalized on the balance sheet. This will affect financial metrics like current ratio, leverage ratio, and return on assets.
  • Income Statement: Operating leases will still be reported as a straight-line expense on the income statement. There is not expected to be significant change from ASC 842.