Balance Sheet – ASC 842 Lease Accounting

Where Leases Appear on the Balance Sheet

A lessee records a right-of-use asset and a lease liability for most leases, operating and finance. It shows them separately from each other and from other assets and liabilities (ASC 842-20-45-1). It can present them on the face of the balance sheet or disclose them in the notes.

The Codification says a lessee "shall either present in the statement of financial position or disclose in the notes" those amounts. ASC 842-20-45-1 is reproduced in EY, Financial reporting developments: Lease accounting. If it combines them with other lines, it must disclose which line items include them (ASC 842-20-45-2).

One combination is prohibited. A lessee may not put finance lease ROU assets in the same line item as operating lease ROU assets. The same holds for the two kinds of liability (ASC 842-20-45-3). A company with both lease types therefore tracks four balances: two ROU assets and two lease liabilities.

Why finance and operating leases stay apart

KPMG, Handbook: Leases explains the reasoning in the FASB's basis for conclusions (paragraph 6.9.80). The Board viewed a finance lease as closer to buying the asset and an operating lease as renting it, so one line for both would mislead. The same handbook notes that operating lease liabilities are presented as operating liabilities rather than debt (paragraph 6.9.60).

An illustrative balance sheet excerpt

The excerpt below is illustrative, not a required format. It shows one year after commencement, just after the first annual payment. The operating lease is a four-year office lease paying $100,000 at the end of each year. The finance lease is a three-year equipment lease paying $50,000 at the end of each year, amortized straight-line.

Both leases use a 6% discount rate. Neither has prepaid rent, lease incentives or initial direct costs. We computed the current portion of each liability as the next payment less the interest it contains, one of the approaches KPMG, Handbook: Leases accepts (Question 6.9.10). The operating lease follows KPMG's Example 6.9.10, scaled to thousands.

The operating lease liability is the present value of three remaining $100,000 payments at 6%. The finance lease liability is the present value of two remaining $50,000 payments. How those amounts are built is covered in our guide to how to calculate the ROU asset and our explanation of what a lease liability is.

The Purpose of the Changes and How It Affects the Balance Sheet

Let's start with the purpose of the ASC 842 changes. One of the basic goals was to increase the disclosures of all leasing obligations for both private companies and public organizations, the idea being to provide more visibility and transparency.

So how does that apply to the balance sheet? Well, prior to ASC 842, most leases weren't even included on a balance sheet, but that's not the case any more. Under the new standard, companies now have to report right-of-use (ROU) assets and liabilities for nearly all of their leases.

This change makes it easier for those using financial statements to evaluate a company's exposure to risk in the leases they list. It also accurately reflects the true financial position of each company and organization, and it allows a more balanced comparison of different organizations.

Leaving the international standards aside for a moment, let's take a before and after example. Under the previous ASC 840 operating standard, capital leases were the only leases that had to be listed on a balance sheet, with the appropriate accounting standards applied.

Operating leases were nowhere to be found on the balance sheet. They were disclosed only in the notes, chiefly through a schedule of future minimum rental payments.

Under ASC 842, however, all leases appear on the balance sheet except short-term leases, which a lessee may elect, by class of underlying asset, to leave off (ASC 842-20-25-2). The listings must also include the lease liability, along with the ROU assets.

The notes to the financial statements carry more. A lessee discloses the weighted-average discount rate and remaining lease term, each separately for finance and operating leases. It also discloses the cash paid for amounts included in the measurement of lease liabilities (ASC 842-20-50-4(g)).

Finally, a more thorough maturity analysis must be included with the disclosure material, and that analysis must be tied to the specific numbers on the balance sheet.

What About Short-Term Leases?

Short-term leases don't have to be included if the lessee elects the exemption (ASC 842-20-25-2). Let's do a quick rundown on what they are and how they're now handled under ASC 842.

A short-term lease has a lease term of 12 months or less at the commencement date. It also has no option to purchase the underlying asset that the lessee is reasonably certain to exercise (ASC 842 Master Glossary).

A renewal option matters only through the lease term. It extends the term when the lessee is reasonably certain to exercise it (ASC 842-10-30-1; illustrated in ASC 842-20-55-15).

A lessee that makes the election doesn't recognize them on the balance sheet, but the payments can be accounted for on a straight-line basis over the terms of the lease. This method is similar to the procedures that were used under ASC 840, so there are no major changes there.

How About Finance Leases?

ASC 842 changes the balance sheet far less for finance leases, which were formerly known as capital leases. These leases were basically purchasing arrangements, and the mechanics carry over.

Capital leases under ASC 840 and finance leases under ASC 842 are both capitalized on the balance sheet, and the procedures for doing this are similar. The way the ROU asset is amortized and the liability accreted is substantially the same as under ASC 840. The subsequent accounting differs substantially, though. A finance lease must be monitored for reassessment events, remeasured when one occurs, and modified under ASC 842's own rules (KPMG, Handbook: Leases, paragraphs 6.4.130-6.4.140).

The numbers can still differ. ASC 842 defines lease payments differently from ASC 840's minimum lease payments. For a finance lease with a lessee residual value guarantee, the asset and liability are generally smaller (KPMG, paragraph 5.4.480).

But What About Operating Leases?

There are changes with regard to operating leases as well, so let's start with a basic definition of what these are under ASC 842. In any lease, the lessee controls the use of an asset it does not own. A lease is an operating lease when it meets none of the finance lease classification criteria (ASC 842-10-25-3).

With the old ASC 840 standard, operating leases were basically unrecorded liabilities. Under ASC 840, operating lease obligations were not recognized on the balance sheet. Only timing balances, such as accrued or deferred rent and initial direct costs, appeared there. They now must be capitalized on a balance sheet, and this will have a considerable material impact on the numbers and the overall state of the balance sheet going forward.

At commencement, an operating lease is recorded the way a finance lease is: the lessee recognizes an ROU asset and a lease liability (ASC 842-20-25-1). After commencement, the two types diverge in how expense is recognized.

Subsequently, the operating lease liability is measured at the present value of the lease payments not yet paid. It uses the discount rate set at commencement, unless updated on remeasurement (ASC 842-20-35-3(a)). The ROU asset is measured at the liability adjusted for prepaid or accrued lease payments, remaining incentives and unamortized initial direct costs (ASC 842-20-35-3(b)).

In practice the asset declines each period by the straight-line lease cost less the accretion on the liability. In EY, Financial reporting developments: Lease accounting (Illustration 4-13), the first-year decline of $10,602 is $12,000 of straight-line cost less $1,398 of accretion.

The ROU asset and liability sit on the balance sheet. The expense goes through the income statement as one straight-line lease cost.

What Changed From ASC 840 on the Balance Sheet

The table compares what a lessee recorded before and after, using KPMG, Handbook: Leases. The largest change is operating leases. Under ASC 842, classification no longer decides whether a lease is on the balance sheet; it decides how expense and cash flows are presented.

KPMG says recognizing operating leases "will significantly increase reported assets and liabilities for some lessees" (Executive summary).

Current and Non-Current Presentation

On a classified balance sheet, ROU assets and lease liabilities get the same considerations as other nonfinancial assets and financial liabilities (ASC 842-20-45-1). KPMG reads that to mean the ROU asset is not split into current and non-current parts, while the lease liability is (Question 6.9.10).

KPMG describes two acceptable ways under ASC 210 to size the current portion of the liability. The rules and examples are in our article on current and non-current lease liability classification, so we do not repeat them here.

What Goes in the Notes, Not on the Balance Sheet

The balance sheet shows balances. The footnote carries the supporting detail, including the weighted-average remaining lease term and discount rate (ASC 842-20-50-4(g)). It also includes a maturity analysis of lease liabilities, with a reconciliation of the undiscounted cash flows to the liabilities on the balance sheet (ASC 842-20-50-6).

See the ASC 842 disclosure footnote page for the full list. For how the balance sheet figures feed leverage ratios and loan covenants, read how ASC 842 affects financial ratios and covenants.

Leases also affect the other statements. See how balance sheet reporting fits the full financial statement set, the income statement and the statement of cash flows. For the whole picture of ASC 842's financial statement impact, see our ASC 842 Complete Guide.