ASC 842 Operating lease example
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ASC 842 Overview
The ASC 842 Lease Accounting Standard
In 2019, the latest FASB standard on lease accounting, ASC 842 (ASU 2018-11), went into effect for most public companies. Other entities, including private companies, were granted a later adoption date, which has now been extended to years beginning after December 15, 2021 and interim periods within fiscal years beginning after December 15, 2022. Among other requirements, ASC 842 declared that most leases need to be capitalized and recorded on to the balance sheet.
The new lease accounting standard
Why the ASC 842 standard was introduced
The financial statement fraud in Enron, WorldCom and others were drivers to the creation of the lease accounting standard. ASC 842 closed the loophole which allowed corporations to hide certain assets and liabilities off-balance sheet. Under the standard, companies are required to capitalize most leases on the balance sheet — reporting them as right-of-use assets and lease liabilities. As a result of the shift, capitalized lease obligations face increased auditor scrutiny, pushing companies to focus on ensuring accuracy and completeness of what they report as well as leading to greater transparency and comparability of financial statements.
Handbook
ASC 842 guide
This is a brief introduction to ASC 842. For more detail on the technical lease accounting as well as how companies can successfully achieve and maintain compliance with the standard, download our full ASC 842 Handbook.
When is the ASC 842 effective date?
The following is a table showing when private companies need to transition to the new lease accounting rules: Early adoption is permitted for all organizations, but very few major public companies elected to early adopt. It is expected that private companies will follow the same pattern for adopting ASC 842 guidelines. This is primarily because the transition process is a huge undertaking and ongoing compliance requires new processes, controls and often FTEs. Organizations with sizable lease portfolios should make use of all the time between now and the ASC 842 effective date to identify leases, extract data, input data into a lease accounting system, and test the system under the standard’s rules, among other steps.
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The major lease accounting changes with ASC 842
- The most notable change is the capitalization of operating leases, which occurs under both FASB’s ASC 842 and the International Accounting Standard Board’s IFRS 16. However, the FASB and IASB split on how to classify leases to be capitalized on the balance sheet, with the FASB having determined a dual classification model of operating and finance leases, while the IASB determined that all on balance sheet leases will be accounted for as finance leases.
- Under finance lease accounting, an asset and a liability are recorded at the present value of the 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 are recorded as a straightline amortization expense plus a declining interest expense.
- Under the FASB’s operating lease accounting standard, operating leases are capitalized similarly to finance leases (previously called capital leases under ASC 840). However, the profit and loss (P&L) expense remains as the a straight-line average expense.
- The FASB and the IFRS allows a short-term lease (12 months or less) exemption from lease capitalization. The IASB allows an exemption from capitalization for leases less than or equal to $5,000 in value.
Classifying leases with ASC 842
Check how your leases are classified under ASC 842 using this lease classification decision tree.
