ASC 842: Everything accountants need to know

Discover how ASC 842 brings leases onto the balance sheet, empowering you with accurate financial reporting. Unravel the complexities and explore alternatives. Get ready to take your accounting practices to new heights with this transformative standard.

What is ASC 842?

ASC 842, also known as Accounting Standards Codification 842, is a set of lease accounting rules issued by the Financial Accounting Standards Board (FASB). It provides guidelines for how businesses should recognize, measure, and disclose leases in their financial statements. ASC 842 replaces the previous standard, ASC 840, and introduces significant changes to lease accounting practices.

Why is ASC 842 important?

ASC 842 is important for accountants and businesses as it brings transparency and improved financial reporting related to lease agreements. By requiring organizations to recognize most leases on their balance sheets, ASC 842 provides a more accurate depiction of a company's financial obligations and commitments. This increased visibility enhances the comparability and consistency of financial statements, benefiting investors, creditors, and other stakeholders.

How does ASC 842 work?

ASC 842 simplifies lease accounting by introducing a dual approach for lease classification: finance leases and operating leases. Finance leases are recorded on the balance sheet as assets and liabilities, while operating leases are treated as rental agreements. 

Accountants must assess lease agreements, determine their classification, measure assets and liabilities, allocate expenses, and provide detailed disclosures according to ASC 842. This standard enhances transparency and improves financial reporting of lease arrangements.

What are the benefits of ASC 842?

Implementing ASC 842 provides several benefits for accountants and businesses:

• Improved Financial Transparency: ASC 842 ensures lease obligations are accurately reflected on the balance sheet, providing a more comprehensive view of a company's financial position.
• Enhanced Decision-Making: With more visibility into lease commitments, businesses can make better-informed decisions regarding lease renewals, expansions, and portfolio optimization.
• Streamlined Compliance: ASC 842 helps organizations adhere to accounting standards, reducing the risk of non-compliance and associated penalties.
• Increased Investor Confidence: By aligning lease accounting practices across industries, ASC 842 promotes consistency and comparability, enhancing investor confidence and trust.

Are there any downsides to ASC 842?

While ASC 842 brings many advantages, it's important to consider potential challenges:

• Implementation Complexity: Adopting ASC 842 may require significant effort and resources to gather lease data, establish new processes, and update accounting systems.
• Increased Administrative Burden: ASC 842 demands ongoing lease tracking, analysis, and disclosure, which can be time-consuming and resource-intensive for businesses with large lease portfolios.
• Financial Impact: Depending on lease arrangements, recognizing leases on the balance sheet may affect financial ratios, key performance indicators, and compliance with debt covenants.

What is the scope and applicability of ASC 842?

ASC 842 has a broad scope and applies to most lease arrangements involving tangible assets while excluding leases of intangible assets and those with a term of 12 months or fewer. Previously off-balance-sheet operating leases now need to be recognized on the balance sheet. 

The standard covers leases of tangible assets like real estate, equipment, and vehicles. However, leases of intangible assets, such as software licenses and patents, fall outside the scope of ASC 842. Short-term leases with a term of 12 months or less are exempt from recognition and measurement requirements but still require disclosure.

ASC 842 provides guidance on recognizing and measuring leases accurately. It differentiates between finance leases and operating leases based on specific criteria. Finance leases are treated as purchases, resulting in the recognition of lease assets and liabilities on the balance sheet. 

Operating leases, although not recorded on the balance sheet, require disclosure of lease-related information. Lease liabilities under ASC 842 are measured as the present value of lease payments, including fixed and variable payments, options to extend or terminate leases, and any penalties. 

Lease assets, on the other hand, are initially measured at the lease liability amount, adjusted for lease incentives, initial direct costs, and any lease payments made before the lease commencement date. These measurements and adjustments ensure an accurate representation of lease-related obligations and commitments in the financial statements.

How do you modify and reassess lease?

ASC 842 addresses lease modifications and the reassessment of lease arrangements during their term. Here's what you should know about making changes to existing leases:

• Lease modification accounting: When lease terms change, such as lease extensions, modifications to lease payments, or changes in lease scope, organizations need to reassess lease classification and adjust the lease liability and asset accordingly.
• Substantive vs. non-substantive modifications: Lease modifications that result in a change to the scope or lease term are considered substantive modifications and require reassessment. Non-substantive modifications, such as changes to lease payments due to index or rate changes, may not require reassessment.
• Reassessment of lease liabilities: Reassessment of lease arrangements may require organizations to re-assume the lease liability based on the updated lease terms and conditions.
• Lease asset adjustments: Adjustments to the lease asset are generally made based on the revised lease liability amount and any changes in lease payments or lease terms.

Presentation and disclosure requirements?

ASC 842 introduces new presentation and disclosure requirements for lease arrangements in financial statements. Lease liabilities and right-of-use assets should be presented separately from other liabilities and assets on the balance sheet. 

Lease expenses should be systematically and consistently presented, typically as separate line items in the income statement or as footnotes. Additional mandated disclosures include significant judgments, assumptions, lease terms, discount rates, and any uncertainties or risks related to leases. A maturity analysis of lease obligations, categorized by years, is also required to provide an overview of future lease payments.

Impact of ASC 842 on financial statements and disclosures?

ASC 842 has a significant impact on financial statements and disclosures. Here's how it affects various aspects of financial reporting:

• Balance sheet: ASC 842 brings lease assets and liabilities onto the balance sheet, resulting in increased total assets and liabilities, potentially impacting financial ratios and key performance indicators.
• Income statement: Lease expenses are typically recognized on a straight-line basis over the lease term, replacing the previous operating lease expense recognition.
• Cash flow statement: ASC 842 affects the classification of cash flows related to lease payments, resulting in changes to the presentation of operating, financing, and investing activities.
• Enhanced disclosures: ASC 842 introduces new disclosure requirements, such as detailed information about lease arrangements, lease costs, discount rates, and maturity analysis, providing stakeholders with more transparency and insight into lease-related obligations.

History and timeline of ASC 842

ASC 842 was developed by the FASB as a response to the limitations of the previous lease accounting standard, ASC 840. The project aimed to address concerns regarding transparency and comparability. FASB issued exposure drafts and sought feedback from stakeholders, leading to the development of ASC 842. 

It was issued in February 2016 and replaced ASC 840, with the implementation effective date extended to different types of organizations. ASC 842 represents a significant milestone in lease accounting standards, enhancing financial reporting and providing a more accurate portrayal of lease-related obligations.

ASC 842 has significantly impacted lease accounting practices, leading many organizations to adopt or implement the standard. This has involved gathering lease data, updating accounting systems, and establishing new processes. 

One key outcome of ASC 842 is increased financial transparency, as most leases must now be recognized on balance sheets. This transparency provides stakeholders with a better understanding of a company's lease-related obligations. 

However, implementing ASC 842 has presented challenges such as collecting lease data, evaluating contracts, and accurately classifying leases. Businesses have had to adjust their accounting practices and maintain ongoing compliance, including lease tracking, reassessment, and enhanced disclosures. Staying informed about FASB's guidance is essential for maintaining compliance with the standard.

ASC 842 is set to shape lease accounting practices and financial reporting in the future. Refinements, interpretations, and guidance from accounting bodies will address implementation challenges, while automation and technology solutions will streamline processes. 

Efforts for global convergence with international standards will promote consistency across countries. The adoption of ASC 842 will enhance lease-related information for financial analysis, leading to more accurate assessments of companies' financial status. The future of ASC 842 offers opportunities for improved reporting, efficiency, and informed decision-making as businesses embrace the benefits of the standard.

Frequently asked questions 

Is ASC 842 applicable to all types of leases?

ASC 842 applies to most leases, including real estate, equipment, vehicles, and other tangible assets. However, it excludes leases with a term of 12 months or fewer and leases of intangible assets.

What is ASC in GAAP?

ASC stands for Accounting Standards Codification, which is the comprehensive set of accounting standards used in the United States under GAAP. ASC provides guidance on various accounting topics, including lease accounting (ASC 842), revenue recognition (ASC 606), and financial statement presentation. It ensures consistent and standardized accounting practices across different industries.

What is an ROU asset?

ROU stands for right-of-use, and an ROU asset represents the lessee's right to use the underlying leased asset over the lease term. Under ASC 842, lessees recognize ROU assets on their balance sheet for operating leases and finance leases. The ROU asset is initially measured at the lease liability amount, adjusted for certain items, and subsequently depreciated over the lease term.

Who must comply with ASC 842?

ASC 842 applies to both lessees and lessors and requires lessees to recognize most leases on their balance sheets as right-of-use assets and lease liabilities, bringing more transparency to lease accounting.

Do service contracts fall under ASC 842?

Service contracts generally do not fall under ASC 842. ASC 842 primarily focuses on leases of tangible assets, whereas service contracts typically involve the provision of services rather than the transfer of a right to use an underlying asset.

Does ASC 842 replace deferred rent?

ASC 842 does not replace deferred rent. Under ASC 842, certain lease incentives and costs may need to be deferred and recognized over the lease term, but deferred rent typically refers to a different concept where rent payments are postponed or accumulated to be recognized in future periods, often due to contractual arrangements or payment agreements.