Are you prepared for the biggest change to lease accounting in over 40 years? The ASC 842 lease is here to shake up the world of finance and accounting. It comes with a plethora of changes and challenges for businesses across industries.
Don’t get caught by non-compliance penalties or lose out on potential business advantages. In this series, we’ll dive deep into ASC 842’s scope.
Whether you’re a financial analyst, business owner, or curious. Get ready to master the ASC 842 lease and stay ahead of the game.
What Is ASC 842 Lease?
The new accounting standards provide guidance on how to account for leases. It replaces (ASC 840). It requires companies to recognize most leases on their balance sheet.
Scope and Subtopics
ASC 842 applies to all leases, except for those with a term of 12 months or less or leases of low-value assets. The standard includes subtopics related to leasing classification. These include:
The standard requires companies to measure their lease liability and right-of-use assets at the lease commencement date. The lease liability is measured at the current value of lease payments. The right-of-use asset is measured at the lease liability amount. It is then adjusted for initial direct costs and lease incentives.
The standard requires companies to remeasure their lease liability and right-of-use assets over the lease term. This reflects changes in lease payments or lease modifications.
It provides guidance on how to account for lease modifications, such as lease extensions or changes in lease payments. The standard requires companies to reassess the lease classification. They must remeasure the lease liability and right-of-use assets if a modification results in a significant change in the lease terms.
ASC 842 requires companies to disclose information about their lease arrangements. Companies must provide qualitative information about assumptions and judgments used in determining lease assets and liabilities. This includes:
- The lease term
- Payment terms
- Lease assets
- Liabilities recognized on the balance sheet
It requires companies to determine whether a lease is an operating lease or a finance lease. This determination affects how the balance sheet accounts for the lease and the income statement.
Entities that Must Comply
All public companies, private companies, and not-for-profit organizations that enter into leases must comply with ASC 842. This includes entities that lease assets such as real estate, equipment, and vehicles.
What’s the Lease under ASC 842?
The lease under ASC 842 is a contract. It conveys the right to control the use of an identified asset for a period of time in exchange for consideration.
The identified assets can be tangible, such as a building or a piece of equipment. It can be intangible, such as software or a patent.
This means the lessee has the right to obtain all of the economic benefits from the use of the identified asset. They also have the right to direct the use of the identified asset.
Consideration can be fixed or variable payments. This includes any amount paid by the lessee to the lessor before or after the lease term.
Transitioning from ASC 840 to ASC 842 requires significant changes in how leases are accounted for, especially for lessees. The changes include recognizing most leases as assets and liabilities on the balance sheet.
You must classify leases as finance or operating leases. This means using the lessee’s incremental borrowing rate to calculate the current value of lease payments. You must provide more extensive disclosures about lease arrangements.
Implementation efforts involve:
- Identifying lease arrangements
- Gathering lease data
- Implementing new processes and controls for lease accounting
How to Account for Operating Leases?
ASC 842 requires lessees to recognize the lease liability and right-of-use assets on the balance sheet for operating leases. Lessees must identify lease agreements that meet the definition of a lease.
They must measure the lease liability at the present value of lease payments using the incremental borrowing rate. They must recognize the right-of-use asset at the lease liability amount.
This must be adjusted for incentives and initial costs. Lease payments must include interest expenses and lease liability reductions and recognize lease expenses on a straight-line basis or another systematic method.
ASC 842 vs IFRS 16
Both lease accounting standards require lessees to recognize lease assets and liabilities on the balance sheet. There are some differences between the two standards. These include:
Under IFRS 16, lessees can use the incremental borrowing rate or the rate implicit in the lease to calculate the lease liability. Under ASC 842, lessees must use the incremental borrowing rate.
IFRS 16 uses a single lease classification model for all leases. ASC 842 uses different classification criteria for finance and operating leases.
IFRS 16 requires the lessees to separate the lease and non-lease components of the contract and allocate payments between them. ASC 842 allows lessees to make an accounting policy election without a separate lease or non-lease component. They must instead account for the entire contract as a lease.
IFRS 16 allows the lessees to use a modified retrospective approach or a cumulatively effective approach to transition to the new standard. ASC 842 only allows the lessees to use the modified retrospective approach.
Impairment and Abandonment
Under ASC 842, lessees must assess their leased assets for impairment and abandonment. This involves determining whether the asset’s carrying value on the balance sheet exceeds its recoverable amount. They may recognize an impairment loss if necessary.
Lessees must test their leased assets for impairment when there are indications that the asset’s carrying value may not be recoverable. This could occur if the leased asset’s market value has declined or if the lessee is experiencing financial difficulties. If the asset’s carrying value exceeds its recoverable amount, the lessee must recognize an impairment loss.
Lessees must also consider whether they have a constructive obligation to return the leased asset at the end of the lease term. They must decide whether they will be able to fulfill that obligation.
If there is a determination that the lessee will not be able to fulfill the obligation, they must recognize a liability for the estimated costs of abandoning the leased asset.
ASC 842 vs ASC 840
ASC 842 supersedes ASC 840, the previous lease accounting standard. Both standards require lessees to recognize lease assets and liabilities on the balance sheet. There are some key differences between them.
Under ASC 840, the lessees only had to recognize capital leases on the balance sheet. Operating leases were only disclosed in the footnotes. Under ASC 842, all leases, including operating leases, must be recognized on the balance sheet.
Under ASC 840, leases were classified as either capital or operating leases based on certain criteria. Under ASC 842, leases are classified as either finance or operating leases based on different criteria.
Initial Direct Costs
Under ASC 840, initial direct costs incurred by the lessees in connection with a lease were expensed as incurred. Under ASC 842, initial direct costs are capitalized and amortized over the lease term.
Lessee accounting under ASC 842 requires a modified retrospective approach. ASC 840 did not need any retrospective adjustments to the financial statements.
Sales and Leaseback Transactions
Sale-and-leaseback transactions involve a company selling an asset to another party and immediately leasing the asset back from the new owner.
ASC 842 requires different accounting treatments for sale-and-leaseback transactions. It depends on whether the transaction is classified as a sale or a financing arrangement.
In the case of a sale, the seller-lessee recognizes a gain or loss and can classify the lease as operating or finance. The buyer-lessor classifies the assets and leases as finance.
If it’s a financing arrangement, the seller-lessee continues to recognize the asset, and the buyer-lessor classifies both the asset and lease as a financing arrangement.
Accounting for sale-and-leaseback transactions under ASC 842 involves several key considerations. These considerations are crucial for accurate financial reporting and compliance. These factors include:
- Transfer of control
- Fair value
- Leaseback terms
- Lease classification
Business Combination Guidance
Business combinations occur when one company acquires another company or merges with it. Under ASC 842, companies must follow specific accounting guidance for business combinations.
The accounting treatment for business combinations under ASC 842 involves recognizing and measuring the fair value of assets acquired and liabilities assumed in the transaction. They must be determined as of the acquisition date.
The acquisition company records the acquired assets and liabilities at their fair value on the acquisition date, and any excess purchase price is recorded as goodwill. Goodwill is then tested for impairment annually, or whenever an event occurs, that could indicate a potential impairment.
When accounting for business combinations under ASC 842, companies need to consider several key factors. These include:
- Identification of the acquiring entity
- Measurement of fair value
- Treatment of transaction costs
- Treatment of contingent consideration
Contingent consideration, such as earn-out provisions, is included in the purchase price if it is probable and can be measured reliably.
Sublease and Sublessee Accounting Guidance
ASC 842 has updated the accounting rules for subleases and sublessee arrangements. If a lessee retains responsibility for the leased asset in a sublease, it is accounted for as an amendment to the original lease. If the lessee transfers control of the asset, it is accounted for as a new lease.
Separating lease and non-lease components is also required for accurate accounting, and variable lease payments or options must be separated into separate components for accounting purposes.
Get ASC 842 Compliance with CPCON
The ASC 842 lease has changed the way companies account for their leases. The new standard introduces more transparency in lease accounting. It requires entities to recognize almost all leases on their balance sheet.
Businesses must have a comprehensive understanding of the standard’s requirements to ensure compliance and maximize the benefits that come with it. If your organization is struggling to navigate the complexities of ASC 842, CPCON is here to help.
Our team of experts has extensive experience in lease accounting and can guide you through the process to achieve compliance and maximize value for your organization. Contact us today to learn more.