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The Financial Accounting Standards Board (FASB) issued ASC 842 to replace ASC 840. It is a major change in lease accounting. This overview covers the key points of ASC 842. For a full resource that covers every topic in depth, visit our ASC 842 Complete Guide. The new standard aims to make companies more transparent and easier to compare.
To do that, it requires lessees to recognize right-of-use (ROU) assets and lease liabilities on the balance sheet for all leases with a term of more than 12 months. For short-term leases a lessee may elect, by class of underlying asset, not to recognize an ROU asset and lease liability and instead to recognize the payments as straight-line lease cost (ASC 842-20-25-2). A right-of-use asset is the lessee's right to use the leased asset for the lease term. A lease liability is the lessee's obligation to make the lease payments, measured at present value (ASC 842-20-30-1).
The standard exists to fix the lack of transparency in off-balance sheet leases. The result is a truer picture of what a company owes.
Key takeaways
- ASC 842 replaced ASC 840. Lessees now record a right-of-use asset and a lease liability on the balance sheet for all leases with a term of more than 12 months. For short-term leases a lessee may elect, by class of underlying asset, to recognize the payments as straight-line lease cost instead (ASC 842-20-25-2).
- Lessees still classify each lease as finance or operating. IFRS 16 has no such split for lessees.
- The lease liability is the present value of future lease payments (ASC 842-20-30-1). They are discounted at the rate implicit in the lease when that rate is readily determinable, and otherwise at the lessee's incremental borrowing rate (ASC 842-20-30-3).
- Public entities adopted ASC 842 for fiscal years beginning after December 15, 2018. Non-public entities adopted it for fiscal years beginning after December 15, 2021.
- Transition is modified retrospective, with a choice of the effective date method or the comparative method, and a package of practical expedients eases adoption (ASC 842-10-65-1).
Implementation Challenges and Solutions
Data Collection and Management: One of the main challenges is to gather and manage detailed lease data. This means a full review of every lease contract to identify, extract, and analyze the data points needed for compliance. Solution: To manage this, companies have turned to lease accounting software. It can store, manage, and analyze lease data, and it automates many of the required calculations.
System Upgrades: Moving to ASC 842 often means upgrading IT systems or adding new ones. The accounting and reporting are more complex than before. Solution: Companies should test their current systems against what the standard requires. Then they can weigh tools that offer the needed functions, such as integrated financial reporting and lease management.
Training and Policy Changes: Staff must learn the new standard, and internal policies must be updated to comply with it. Both are extra hurdles. Solution: Full training programs and clear notice of policy updates are essential. Outside consultants and learning resources from accounting bodies can also smooth the transition.
How does ASC 842 differ from IFRS 16?
ASC 842 and IFRS 16 share one goal: to bring lease obligations onto the balance sheet. Still, their approaches differ in critical ways. For example, IFRS 16 does not distinguish between operating and finance leases for lessees. That simplifies the accounting, but it means every lease is accounted for the way Topic 842 treats a finance lease.
This single model under IFRS 16 contrasts with the dual model of ASC 842, which keeps separate accounting for finance and operating leases. Deloitte's Roadmap: Leases sets out the difference in its US GAAP and IFRS appendix.
Why the GASB 87?
If your firm is a governmental entity, or falls under the Governmental Accounting Standards Board (GASB), you will need to comply with GASB 87. GASB 87 is the lease accounting standard designed for state and local governments.
ASC 842 is issued by the Financial Accounting Standards Board (FASB). It applies to entities reporting under US GAAP, including public companies, private companies and not-for-profits (ASC 842-10-65-1(a) and (b)). In short, the jurisdiction and regulatory environment an entity operates in determine which lease accounting standard it follows.
Shifting from the ASC 840
The FASB's move from ASC 840 to ASC 842 changed lease accounting at its core. It addresses the flaws of the old standard, above all its lack of transparency about off-balance sheet lease obligations.
Under ASC 840, a lease was either a capital lease or an operating lease. Only capital leases went on the balance sheet.
Topic 842 brings in a full model where both types—now called finance and operating leases—are recorded on the balance sheet. This change shines a light on obligations that used to be hidden, so corporate financial statements become more transparent. The aim is a truer picture of a company’s leases and their financial impact.
Key Differences
- Scope and Recognition: Topic 842 widens the set of leases that go on the balance sheet. All leases, with limited exceptions, now require recognition of right-of-use assets and lease liabilities.
- Classification and Expense Recognition: Both standards classify leases, but ASC 842 changed the criteria slightly. That alters how expenses are recognized on the income statement.
- Disclosure Requirements: ASC 842 asks for far more detail in the disclosures. Companies must now give extensive qualitative and quantitative details about their leasing arrangements.
- Balance Sheet Impact: Topic 842 requires that right-of-use assets and lease liabilities for both finance and operating leases be recognized on the balance sheet. Under ASC 840, only capital leases affected the balance sheet.
- Overall Impact on Business Functions: The transition is a complex process. It reaches beyond accounting to IT system upgrades and possibly to how real estate is managed. It demands a fresh look at lease contracts, updates to policies, and perhaps new systems to manage compliance.
With both lease types on the balance sheet, the standard reveals far more about a company's financial standing and commitments than was required before. These liabilities and assets in the financial statements give stakeholders a complete view of the company's lease obligations. They also make financial statements easier to compare across entities.
Key Lease Calculations
- Lease Liability: The present value of future lease payments, including fixed and certain variable payments. Discount them at the rate implicit in the lease when that rate is readily determinable, and otherwise at the lessee’s incremental borrowing rate (ASC 842-20-30-3).
- Right-of-Use (ROU) Asset: the initial lease liability, plus any lease payments made at or before commencement and any initial direct costs, minus any lease incentives received (ASC 842-20-30-5). The discount rate affects the initial assessment.
- Amortization: For finance leases, an amortization schedule splits each payment between interest and principal, so interest expense falls over the lease term (ASC 842-20-25-5, ASC 842-20-35-1(a)). Operating leases use a straight-line expense method (ASC 842-20-25-6).
- Journal Entries: Record ROU assets and lease liabilities at the start. Finance leases also record interest and amortization of the ROU asset as separate entries. Operating leases record a single lease expense.
ASC 840 split leases into capital and operating. ASC 842 instead gives one uniform framework that puts nearly all leases on the balance sheet. That improves financial transparency and comparability.
Lease Classification Methods
Treatment For The Lessee
Under Topic 842, a lessee's leases fall into two categories: finance and operating leases. The classification dictates the accounting treatment and how the lease appears in the financial statements.
Finance Leases:
- The right-of-use asset is an entry in the statement of financial position, and so is the lease liability. Unlike an operating lease, amortization and interest expense are separate entries in the income statement.
- In the statement of cash flows, variable lease payments fall under operating activities, while principal repayments fall under financing activities (ASC 842-20-45-5). Interest on the lease liability is classified according to ASC 230.
Operating Leases:
- For the lessee, lease expense is an income statement entry under operating expenses, recorded on a straight-line method over the lease term. The figure is the sum of the interest expense and the right-of-use asset's amortization. The interest is calculated on the effective interest rate basis. The amortization is the difference between the lease's straight-line expense and the interest expense on the lease liability.
- The standard also requires the right-of-use asset to be recorded on the balance sheet together with the lease liability. The asset is tested for impairment under ASC 360 (ASC 842-20-35-9, applying Section 360-10-35). Operating lease payments also appear in the statement of cash flows, under operating activities.
Both classifications require the lessee to give enhanced disclosures, so readers get more insight into its leasing activities. Through these recognitions and disclosures, ASC 842 ensures lessees show a complete picture of their lease obligations. That promotes transparency and lets users of financial statements make better-informed decisions.
Treatment For The Lessor
Under Topic 842, a lessor classifies each lease as a sales-type lease, a direct financing lease, or an operating lease (ASC 842-30-05-1; classification criteria in ASC 842-10-25-2 through 25-3A). The classification dictates the accounting treatment and how the lease appears in the financial statements.
Operating Leases:
- Here the lessor keeps the underlying asset on its balance sheet and continues to depreciate it under its normal depreciation policy; no lease asset is recognized (ASC 842-30-30-4). PwC's Leases guide, section 4.5 makes the depreciation point. Depreciation and revenue from the lease are also accounted for at gross amounts in the company's income statement.
- Another key rule: all cash receipts from the leases are entered in the cash flow statement under operating activities (ASC 842-30-45-5).
Sales Type Lease:
- For a sales-type lease, the new standard requires the lessor to record lease interest income and receivables. The lessor derecognizes the asset. In its place, the net investment in the lease is the entry on the balance sheet, also called the statement of financial position. The net investment in the lease is the lease receivable, which is the present value of the lease payments plus the present value of any guaranteed residual value, plus the unguaranteed residual asset, itself measured at present value (ASC 842-30-30-1).
- Interest income is added to the net investment in the lease, and collected payments are deducted from it. ASC 842 also directs that the selling profit or loss be recorded in the income statement at lease commencement. The effective interest rate formula is used to calculate the interest income.
- As with an operating lease, all cash receipts from the lease go in the cash flow statement under operating activities, unless the lessor is a financial institution within the scope of ASC 942 (ASC 842-30-45-5).
Direct Financing Lease:
- As above, this type of lease derecognizes the underlying asset and recognizes the net investment in the lease on the balance sheet (ASC 842-30-25-7). It is measured under ASC 842-30-30-2, which uses the same components as a sales-type lease, reduced by any selling profit. The net investment, interest income, collected payments, and cash receipts are treated much as they are for a sales-type lease.
- Selling loss is recorded at the beginning of the lease while profit is deferred.
Practical ASC 842 Example
To see ASC 842 in action, consider a company that leases several delivery vehicles with different lease terms and payment structures. Each lease must be evaluated on its own to determine the ROU asset and lease liability. Factors include the discount rate, the lease term, and the payment structure. Examples like this show the complexity and judgment the standard demands, and why detailed lease analysis and documentation matter.
ASC 842 requires all leases to be recorded on the balance sheet. That reveals lease liabilities and ROU assets that used to be hidden. Central to this is a discount rate, used to calculate the present value of lease payments. That is a break from ASC 840's approach.
What must lessees disclose under ASC 842?
ASC 842 greatly expands the disclosure requirements for both lessees and lessors. Lessees must give a qualitative and quantitative explanation of their leasing activities (ASC 842-20-50-1). That covers the nature of their leases, the significant judgments made, and the amounts recognized in the financial statements.
Lessees must also disclose a maturity analysis of lease liabilities, showing future lease payments broken out by year and by lease type (ASC 842-20-50-6). These disclosures aim to give stakeholders a full understanding of an entity's leasing obligations and the impact on its financial position.
What transition options and practical expedients does ASC 842 offer?
ASC 842 offers entities several transition options and practical expedients to ease the burden of adoption. A practical expedient is a simplification the standard permits. The best-known relief is the package of three practical expedients, elected all or not at all: an entity need not reassess whether expired or existing contracts contain leases, need not reassess lease classification for those leases, and need not reassess whether previously capitalized initial direct costs still qualify (ASC 842-10-65-1(f)).
Topic 842 requires a modified retrospective transition. An entity chooses the date of initial application: under the effective date method it recognizes the cumulative-effect adjustment at adoption and leaves comparative periods under ASC 840; under the comparative method it applies Topic 842 to all comparative periods presented (ASC 842-10-65-1(c)). KPMG's Handbook: Leases uses those two method names. Choosing among the transition methods and practical expedients takes careful thought about their impact on financial reporting and operations.
Impact on Specific Industries
Topic 842 hits hardest in industries with large operating lease commitments, such as retail, aviation, and real estate. In retail, where store leases are common, the new standard has a big effect on balance sheet metrics. That can affect loan covenants and financial ratios.
In aviation, companies that lease aircraft will see major changes in how those leases are accounted for and reported. Entities need to grasp what the standard means for their industry so they can prepare for the changes.
Industry Best Practices and Compliance Strategies
Best practices matter for a successful transition from ASC 840. They include a thorough review of the lease portfolio, using technology for lease management and accounting, and cross-functional teams that cover compliance from every angle. It also helps to engage early with stakeholders, including auditors, lenders, and investors, to explain the new standard's impact on the financial statements.
Effective Dates
United States public entities adopted ASC 842 for fiscal years beginning after December 15, 2018. United States non-public entities adopted it for fiscal years beginning after December 15, 2021, following the deferrals in ASU 2019-10 and ASU 2020-05 (ASC 842-10-65-1(a) and (b)). For a fuller explanation of the effective dates, see The New Standard's Effective Dates.
The Importance of Transitioning
FASB Topic 842 aims to close the loopholes in ASC 840, above all for off-balance sheet items. Here are the major benefits of the new standard:
- It promotes transparency about the entity's liabilities under its lease agreements, especially operating leases.
- It helps standardize accounting for all leases classified under US GAAP.
- It lowers the number of off-balance sheet items. Leases that used to sit off the balance sheet, such as operating leases, are now balance sheet transactions.
- It improves disclosure to investors of critical information about lease arrangements. An entity that buys capital-intensive equipment shows the high debt on its balance sheet. One that leased the same equipment could look healthier, even though its lease payment obligation was just as high.
- For a more detailed explanation see: Transitioning To The ASC842
Summary
The standard forces a major shift in lease accounting, with a stress on transparency and comparability across entities. Entities that understand the implementation challenges, know how the global standards differ and align, and work practical examples into their compliance efforts can manage the transition better. The expanded disclosures under Topic 842 also raise the quality of information for stakeholders. That gives a deeper view of an entity's leasing activities and financial obligations.
The transition options and practical expedients give flexibility and relief during adoption. Entities can pick the approaches that best fit their circumstances. Still, choosing them takes careful thought about what they mean for financial reporting and operations.
The impact reaches across industries, and each faces its own challenges. Entities must assess what the new standard means for their industry and build a compliance strategy to match. That includes the likely effects on financial ratios, loan covenants, and financial reporting as a whole.
Best practices for a smooth transition include a thorough lease portfolio review, technology that streamlines lease management and accounting, and cross-functional teams that cover compliance in full. Engaging key stakeholders early and often is critical. It manages expectations and explains the impact of ASC 842 on the financial statements.
In short, the move from ASC 840 is a critical update to lease accounting, built to give a truer picture of an entity's lease obligations. Entities that plan the transition with care, and use the right tools, resources, and strategies, can reach compliance while improving their transparency and the confidence of stakeholders. Companies that embrace the changes in ASC 842 do more than comply. They also gain useful insight into their lease portfolios, which supports better financial and operating decisions.
iLeasePro for Your ASC 842 Lease Accounting Day 1 and Day 2
iLeasePro is robust lease management and accounting software. It is built to streamline both Day 1 and Day 2 tasks under ASC 842, and it gives full support to companies working through the complexities of lease accounting.
On Day 1, iLeasePro simplifies the initial identification, classification, and measurement of leases. Its tools automate the evaluation, so leases are recognized on the balance sheet correctly from the commencement date. It calculates the present value of lease payments, which helps establish the lease liabilities and the matching ROU assets. It also factors in initial direct costs and determines the appropriate discount rate.
On Day 2, iLeasePro keeps delivering value by supporting the ongoing upkeep of lease accounting. The software updates lease liability measurements and ROU asset amortization on a regular basis. It handles lease modifications and keeps financial reporting accurate and compliant over the lease term.
The disclosure features in iLeasePro also let companies produce detailed reports with ease, so disclosure reporting stays transparent and compliant. With one platform that supports both Day 1 and Day 2 with speed and precision, iLeasePro helps companies manage their lease portfolios well. They stay compliant with lease accounting standards while the administrative burden shrinks.
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iLeasePro lease accounting software is a robust solution that makes lease management and reporting a breeze. If you want to handle lease standard compliance with ease and see your data more clearly, take a tour of iLeasePro to learn more.