Understanding the New Lease Accounting Standard
Overview of ASC 842
ASC 842, also called ASU 2016-02, is the new lease accounting standard published by the Financial Accounting Standards Board (FASB). It will replace the previous FASB lease accounting standard, ASC 840. The purpose of the new standard to close a major accounting loophole in ASC 840: off-balance sheet operating leases. 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.
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.
Major Changes from ASC 840
Under ASC 840, corporations could 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 limit smaller investors who don’t have the resources to dig through financial statements and determine corporations’ 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.
ASC 842 will still classify leases into finance leases (capital leases under ASC 840) and operating leases. Short-term leases, which have a term less than or equal to 12 months, do not have to be reported on balance sheet.
Check how your leases will be classified under ASC 842 using the lease classification tool:
Impacts to Financial Statements
The transition to ASC 842 could impact corporate financial statements.