ASC 842, the new lease accounting standard issued by the Financial Accounting Standards Board (FASB), has significantly changed how leases are accounted for and reported on financial statements. Effective for public companies for fiscal years beginning after December 15, 2018, and for private companies for fiscal years beginning after December 15, 2021, ASC 842 aims to increase transparency and comparability in lease accounting by requiring lessees to recognize most leases on their balance sheets. In this blog post, we'll explore the key provisions of ASC 842 and how it impacts lease accounting.
1. Lease Classification: ASC 842 introduces a new classification model for leases based on whether the lease transfers substantially all the risks and rewards of ownership to the lessee. Leases that meet certain criteria, such as containing a transfer of ownership, have a lease term that is a major part of the asset's economic life, or include a purchase option that is reasonably certain to be exercised, are classified as finance leases. All other leases are classified as operating leases.
2. Recognition and Measurement: Under ASC 842, lessees are required to recognize right-of-use (ROU) assets and lease liabilities for all leases with a term of more than 12 months on their balance sheets. The ROU asset represents the lessee's right to use the underlying asset during the lease term, while the lease liability represents the lessee's obligation to make lease payments over the lease term. Initial measurement of the ROU asset and lease liability is based on the present value of lease payments, including fixed payments, variable payments based on an index or rate, and residual value guarantees.
3. Lease Term and Discount Rate: Determining the lease term and discount rate is crucial for calculating the present value of lease payments. The lease term includes the noncancellable period of the lease plus any optional renewal periods if the lessee is reasonably certain to exercise the option. The discount rate used to calculate the present value of lease payments is the lessee's incremental borrowing rate, unless the rate implicit in the lease is readily determinable.
4. Subsequent Measurement: After initial recognition, lessees are required to measure the lease liability using the effective interest method, which amortizes the liability over the lease term. The ROU asset is amortized on a straight-line basis over the shorter of the lease term or the useful life of the underlying asset. Additionally, lessees must reassess the lease term and discount rate if there are changes to the lease contract that are not accounted for as lease modifications.
5. Disclosures: ASC 842 requires enhanced disclosures to provide users of financial statements with information about an entity's leasing activities and the significant judgments made in applying the standard. Disclosures include qualitative and quantitative information about lease obligations, lease terms, lease payments, and other relevant lease terms and conditions.
6. Transition: ASC 842 requires a modified retrospective transition approach, which requires lessees to recognize and measure leases at the beginning of the earliest comparative period presented in the financial statements. The standard provides practical expedients and optional transition methods to simplify the transition process for lessees.
ASC 842 represents a significant change in lease accounting and requires careful consideration and implementation by affected entities. Compliance with the standard may require changes to lease management processes, systems, and internal controls. It's essential for companies to assess the impact of ASC 842 on their lease portfolios, financial statements, and disclosures and to work closely with accounting professionals to ensure proper implementation and compliance with the standard. With proper planning and preparation, companies can successfully navigate the complexities of ASC 842 and improve transparency and comparability in lease accounting.
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