Understanding the New Lease Accounting Standard for US GAAP
ASC 842 Overview
Accounting Standards Codification Topic 842, also known as ASC 842 and as ASU 2016-02, is the new lease accounting standard published by the Financial Accounting Standards Board (FASB). It will replace the previous US GAAP leasing standard, ASC 840, which is almost 40 years old. The purpose of the new standard to close a major accounting loophole in ASC 840: off-balance sheet operating leases. Public companies began to implement the standard starting after December 15, 2018. Private companies will follow a year later on December 15, 2019.
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 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 new accounting standards were developed to impose stricter guidelines on companies after the accounting scandals of the early 2000s. The reasoning behind the leasing changes in particular was to provide users of financial statements, such as lenders and retail and institutional investors, with increased visibility into the leasing obligations of companies.
The definition of a lease has changed slightly. 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 3 criteria:
There must be an identified asset. To qualify as identified, the asset must be physically distinct or the lessee must receive substantially all of the capacity of the asset. In addition, the lessor cannot have substantive rights to substitute the asset.
The lessee must receive substantially all of the economic benefit. To determine what qualifies as “substantially all,” the parties must define the economic benefits of the asset and then determine the allocation of economic benefits.
Direct the Use of Asset
The lessee must have the right to direct the use of the asset. If how the asset will be used was predetermined, the lessee must have the right to operate the asset or they must have designed the asset in a way that predetermines how it will be used.
What are Right-of-Use Assets and Lease Liabilities?
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.
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.
The lease liability is calculated as the present value of the lease payments, using the discount rate specified in the lease, or if that is not available, the company’s incremental borrowing rate (IBR).
Impacts to Financial Statements
Impact to the Balance Sheet
There will be an increase in assets and liabilities on the balance sheet. Under the ASC 840, leases were classified as either capital leases or operating leases. While capital leases were recorded on a company’s balance sheet, the operating leases were 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 capitalized 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.
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.
ASC 842 Lease Classification
ASC 842 will still classify leases into finance leases (called capital leases under ASC 840) and operating leases. However, the classification criteria have somewhat changed. Short-term leases, which have a term less than or equal to 12 months, do not have to be capitalized on balance sheet.
Check how your leases will be classified under ASC 842 using the lease classification tool: