Finding all of your company’s leases and categorizing them can be a complex task as you strive to achieve compliance with the new lease accounting standard — especially for entities with decentralized operations.
ASC 842 lease accounting in particular is a bit more complicated than historical lease accounting, so we’ve outlined some simple tips to help set you up for success.
Everything You Need to Know About the New ASC 842 Lease Accounting Standard:
What is ASC 842?
For a lessee, ASC 842 requires all leases longer than 12 months to be recorded on the balance sheet as right-of-use (ROU) assets with an accompanying lease liability. ASC 842 is initially effective for private companies with fiscal years beginning after Dec. 31, 2021. Therefore, for a calendar year-end company, the effective date is Jan. 1, 2022.
What is a lease?
A “lease” is defined as a contract or an element of a contract that conveys the right of use (ROU) of a physically distinct identified asset for a specified period of time in exchange for payment. ASC 842 defines two types of lease models: an operating lease and a finance lease.
Previously, only capital leases needed to be recorded on the balance sheet. Now, companies will be required to include and report ROU assets and liabilities for almost all leases.
In other words, companies must report ROU assets and lease liabilities for operating leases as well as for finance leases, where IT and office equipment, vehicles, construction equipment and other leased assets may appear on the balance sheet alongside real estate leases.
Where Could Leases Be Hiding?
Leased assets can include computers, telephones, vehicles, heavy equipment and warehouse space. Further, leases can be embedded into service and usage contracts as well as other expenses, proving difficult to find.
Examples of leased assets embedded in arrangements:
- Information technology contracts (e.g. servers)
- Transportation and delivery services (e.g. railcars)
- Contract manufacturing arrangements (e.g. dedicated tooling)
- Complex service contracts (e.g. specified equipment)
- Cable and satellite services (e.g. set-top boxes)
- Advertising (e.g. billboards)
- Power purchase arrangements (e.g. power plants)
- Joint-operating agreements (e.g. drilling rigs)
What is the purpose of ASC 842?
The purpose of ASC 842 is to increase disclosure and visibility into the leasing obligations of both public and private organizations.
These changes make it easier for investors, vendors, government agencies and business stakeholders to (1) see a company’s exposure to risk and true financial position, and (2) make comparisons between organizations.
In addition, ASC 842 closely aligns with the international lease accounting standard, IFRS 16, which makes financial reporting more consistent for organizations with both U.S. and international reporting requirements.
It is important to note that ASC 842 does not include in its scope assets that are covered in other accounting standards, including:
- Intangible assets (ASC 350)
- Minerals and biological assets including timber (ASC 930, 932)
- Inventory (ASC 330)
- Assets under construction (Covered under ASC 360)
How Does ASC 842 Impact Financial Statements?
Under the new lease accounting standard, an ROU asset and a lease liability are recorded at the present value of identified lease payments on the balance sheet, with certain modifications for items such as prepayments and initial direct costs.
On the income statement, the lease costs for an operating lease are recorded as rent expense on a straight-line basis and for a finance lease, amortization of the ROU asset will be recorded separate from the interest expense on the lease liability.
Organizations will need to use either the interest rate from the lease or the practical expedient of the Incremental Borrowing Rate (IBR) to calculate present value. FASB allows a short-term lease (12 months or less) exemption from lease capitalization.
Who Must Comply with ASC 842?
All entities that follow generally accepted accounting principles (‘GAAP’) and have leases longer than 12 months in length must comply with the rules stated in ASC 842.
Why ASC 842 Compliance is Essential – Yet Challenging
ASC 842 compliance is essential for the preparation of accurate financial statements. Without proper adoption, you can run into any number of issues: financial inconsistencies that impede your ability to make informed, data-driven decisions, the potential for stakeholder relationships to become damaged, and many other costly setbacks.
While vital for success, ASC 842 compliance brings many challenges.
The more decentralized an organization is, the more difficult it becomes to work across company lines to ensure the gathering of a comprehensive inventory of contractual agreements that identify all potential lease contracts for evaluation. If there is a lack of accurate historical lease accounting or overlooked financial leases, this process becomes even more complex.
Preparing to comply with ASC 842 often includes company-wide operational rework or the implementation of lease accounting software, which can open up a whole other world of issues.
The best way to ensure a seamless ASC 842 compliance process is by turning to a trusted partner who spends the necessary time and effort to understand the inner workings of your business, goals and operations so they’re able to make informed suggestions about which solutions will be most beneficial.
Whether your situation requires hands-on support to expedite the ASC 842 compliance process or a roadmap for implementing better lease accounting software, Kranz’s experienced team of accountants are here to identify the gaps across your business and provide support where it’s needed most.