The FASB (Financial Accounting Standards Board) published the new ASC 842, which is a new standard for lease accounting. It replaces the previous ASC 840 and aims to overcome its loopholes.
Lease accounting refers to the process through which companies record the financial effect of the agreements to finance or rent the specific rights of using the assets. The changes under the new ASC 842 affect how the two parties, i.e., lessor and lessee, are legally required to report and account for the leases. Below, we get to have an in-depth look at the fundamental things this new accounting standard entails.
About ASC 842
ASC 842 is one of the most important changes in lease accounting. It aims to ensure that all leases are recorded on the balance sheet. The accounting standard requires US public and international entities to recognize all leased items as liabilities or assets and enter the balance sheet. This is irrespective of whether the leases are considered financing or operating leases.
Before ASC 842 and under ASC 840, not all types of leases were recorded on the balance sheet. Most of the others, such as an operating lease, were regarded as off-balance sheet items.
The challenge was that the resulting payment liability on these off-balance sheet items is a real liability. As such, it has an actual financial effect on the entity and needs to be disclosed for transparency with beneficiaries of the organization's financial statements. Failure to report such real liability creates a risk of misrepresentation of the entity's financial position.
Categories of Leases Under the New FASB ASC 842
ASC 842 classifies the lessor's leases into a sales type, operating, and direct financing, while the lessees are either finance or operating lease. It requires that each party determines the lease category at the beginning. This commencement date is when the lessor avails the asset under lease to the lessee.
Whenever the lease contract has several components, under ASC 842, each is categorized separately. Let us look at these lease categories for both the lessor and the lessee.
ASC 842 Lease Categories and Treatment For Lessee
- For the lessee, lease expenses are an income statement entry under operating expense, and they are recorded on a straight-line method for the lease duration. The figure to use is the sum of the interest expense and the right-to-use asset's amortization. While the former is calculated using the effective interest rate basis, the latter is determined as the difference between the lease's straight-line expense and the lease liability's interest expense.
- The accounting standards also require that entries of a right-to-use asset be made on the balance sheet together with those of the lease liability. Impairment is tested on this asset as per the accounting standards ASC 360. In addition, operating lease payments are an entry in the statement of cash flows. They fall under the report's operating activities.
- The right of use asset is an entry in the statement of financial position, and so is the liability lease. Unlike the operating lease, amortization and interest expense are entered as separate entries in the income statement.
- Variable lease payments are categorized under operating activities, while principal repayments are an entry under financing activities in the cash flows statement. The interest of lease liability's classification is made according to accounting standards ASC 230.
ASC 842 Lease Categories and Treatment for Lessor
- Here, the lease will be an entry on the balance sheet. It will be subject to depreciation amortized over the underlying asset's useful life, whereby it might be longer than the lease duration. In addition, depreciation and revenue attributable to the lease are accounted for in the gross amounts in the company's income statement.
- Another vital guideline is that all cash receipts attributable to the leases are entered as a cash flow statement component under operating activities.
Sales Type Lease
- Under the sales-type category, the new standard require that the lessor establish lease interest income and receivables. It derecognizes the asset and instead considers the lease's net investment as the entry into the entity's balance sheet, also known as the statement of financial position. To get the net investment, compute the present value of all the future lease receivables plus its unguaranteed residual quantum.
- The interest income is added while the collected payments are deducted from the lease's net investment. Further, ASC 842 guides that the selling loss or profit be recorded at the commencement of the lease as an entry in the income statement. The effective rate of interest formula helps calculate the interest income.
- As with the operating lease, all cash receipts attributable to the lease are an entry in the cash flows statement under operating activities.
Direct Financing Lease
- Like above, this type of lease derecognizes the asset and instead uses net investment income as the balance sheet entry. The net investment, interest income, collected payments, and cash receipts treatment are also similar to the sales-type lease.
- Selling loss is recorded at the beginning of the lease while profit is deferred.
ASC 842 Implementation and Deadline Dates
US public entities and international ones had a deadline of 15th December 2019 to comply with the ASC 842 accounting standards. US non-public entities compliance deadline became effective for all reporting periods after 15th December 2021.
The Importance of ASC 842
ASC 842 aims to enhance and seal the loopholes of the ASC 840, especially on the off-balance sheet items. Here are the major benefits of the new FASB ASC 842.
• It will promote transparency on the entity's liabilities arising from the various lease agreements, especially the operating leases.
• It will help standardize accounting for all leases classified under US GAAP.
• ASC 842 will lower the number of off-balance sheet activities. Some of the leases that were regarded as off-balance sheet items, e.g., operating leases, are now considered balance sheet transactions.
• Enhance disclosure to investors on critical information affecting lease arrangements. E.g., entities that purchase capital-intensive equipment reflect the high debt on their balance sheets. However, those that lease the same capital-intensive equipment seem to have a healthier balance sheet despite having an equally high lease payment obligation.
Ready To Begin?
Implementing the new standard requires plenty of work. Having a lease accounting software such as iLeasePro makes it easier to retrieve information on the existing leases and categorize them accordingly. You will benefit from features such as Lease Management, Lease Accounting, and Lease Analysis, among others. In addition, it is compliant with the New FASB ASC 842 Lease Accounting Standard.
iLeasePro lease accounting software is a robust solution that makes lease management and reporting a breeze. If you want to navigate the complexities of lease standard compliance with ease and have better data visualization, take a tour of iLeasePro to learn more.