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 replaced the previous US GAAP leasing standard, ASC 840, which is almost 40 years old. he 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, 2020.
What is ASC 842?
Learn how to face the challenges of the US GAAP lease accounting standard.
ASC 842 overview.
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, are now 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.
ASC 842 LEASE DEFINITION
Three criteria for a contract to qualify as a lease.
1. Identified asset
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.
2. Economic benefit
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.
3. Direct 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.
Calculating the asset and liability.
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 ASC 840, capital leases were recorded on a company’s balance sheet, but operating leases were not. Going forward under ASC 842, 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.
TECHNICAL GUIDES & UPDATES
Technical guides from the Big Four and accounting boards.
Since the original publication of a ASC 842 in 2016, the big four and accounting boards have released multiple guides to help companies understand the technical accounting of the new standard.
Deloitte’s guide for private companies
Deloitte’s Lessons Learned from Public Company Implementations covers five critical lessons private companies should be aware of for their ASC 842 projects.
PwC’s ASC 842 video series
PwC’s videos review the impact of the new ASC 842 leasing standards, as well as various technical accounting requirements, including variable payments and the discount rate.