A Guide to Navigating ASC 842 Lease Standards

A Guide to Navigating ASC 842 Lease StandardsWhat Is ASC 842 And When Did It Go Into Effect?

ASC 842, created by the Financial Accounting Standards Board (FASB) in 2016, and now fully in effect for both public and private companies as of 2021, streamlines and ensures more accurate representation of companies’ operating leases. This is a marked improvement from the off-balance-sheet treatment of operating leases that was common before its implementation. 

Lease accounting under ASC 842 has brought significant changes to the financial reporting landscape, impacting how companies recognize and disclose lease agreements. 

What Changes Did ASC 842 Cause?

Previously, operating leases were treated as off-balance sheet arrangements, meaning they wouldn’t be reported within a company’s financials on the balance sheet, but lease payments were still expensed on income statements. This obscured a company's true financial obligations and led to incomplete representation of financial commitments. 

ASC 842 irons out this lack of transparency by requiring the recognition of lease assets and liabilities, creating greater transparency and accuracy in financial reporting.

Now, because of ASC 842, lessees are required to recognize operating leases on the balance sheet by recording a right-of-use asset and a corresponding lease liability. This reflects both the asset's usage rights and the associated lease obligation. Monthly payments now offset the lease liability, and the income statement expense comes from the straight-line amortization of the right-of-use asset.

What Are Lease Agreements?

A lease agreement, quite simply, is a contractual agreement to lease property, plants, or equipment. The lease classification determines the accounting treatment—the way a transaction is recorded and presented; a lease is classified using the following qualifications: 

• Identification of an Asset: The lease involves the use of a specific and identified asset, such as property, plant, or equipment.
• Right to Control: The lessee has the right to control the use of the identified asset, meaning the lessee has the ability to direct the use of the asset and obtains the majority of the economic benefits from its use.
• Consideration: The lessee makes payments (consideration) to the lessor in exchange for the right to use the identified asset. These payments can be fixed or variable.
• Lease Term: The lease has a defined period during which the lessee has the right to control the use of the asset. The lease term may also include options to extend or terminate the lease.

What Classifications Are There in ASC 842?

ASC 842 distinguishes between financing leases and operating leases. A significant difference is that operating leases under 12 months have optional off-balance-sheet treatment, providing flexibility for short-term arrangements, while financing leases are always on the balance sheet. 

Operating Lease

An operating lease is a lease agreement wherein the lessee obtains the right to use an asset for a predetermined period, typically short-term, without the transfer of ownership or substantially transferring the risks and rewards associated with ownership. 

Prior to ASC 842, the lessee recognized lease payments as expenses on the income statement. Under the new lease standard, a company must recognize a Right-of-Use Asset and Lease Liability on the Balance Sheet.

Financing Lease

A financing lease, also known as a capital lease, is a lease agreement in which the lessee effectively assumes the risks and rewards of ownership. It typically involves one of the following:  a longer lease term, a provision for the transfer of ownership to the lessee at the end of the lease term, or the inclusion of a bargain purchase option. Financing leases are capitalized on the lessee's balance sheet, recognizing both a right-of-use asset and a lease liability.

What is a Discount Rate in a Lease?

Discount rates determine the present value of lease payments, aligning financial reporting with economic reality. Determining discount rates is a complex, often challenging calculation. It’s  best practice to apply a conservative estimate if the discount rate is not stated in the lease terms.

Incremental Borrowing Rate

The incremental borrowing rate reflects the hypothetical interest rate a lessee would pay for similar borrowing, considering factors like creditworthiness and economic conditions.

Economic Environment 

The economic environment at lease commencement influences the discount rate, as well. Thorough assessment of factors like inflation rates and market interest conditions which impact borrowing costs is necessary for accurate financial reporting. Despite the complexity, early-stage finance teams can and should use conservative estimates to avoid uncertainty.

Why Do I Need a Lease Schedule?

Proper lease schedules are integral in ASC 842 compliance. Maintaining a comprehensive schedule results in accurate lease tracking and ensures compliance with accounting standards. Proper documentation and journal entries lead to transparent reporting of lease transactions, enhancing financial statement reliability.

Final Thoughts

ASC 842 lease standards represent a paradigm shift in lease accounting, aiming to enhance transparency and accuracy in financial reporting. By recognizing lease assets and liabilities on the balance sheet, companies provide stakeholders with a clearer understanding of their financial position and obligations.

If you have questions about ASC 842, or want to understand how it could impact your company’s financials, please reach out.