Published by the Financial Accounting Standards Board (FASB), the Accounting Standards Codification Topic 842, or simply called as ASC 842, is the new lease accounting standard. Public companies have implemented this new standard for reporting lease financials in December of 2018. Private companies shall follow suit by December of 2019.
What is ASC 842?
ASC 842 replaces ASC 840, which was the previous standard used according to the generally accepted accounting principles (GAAP) in the US. The new standard aims to resolve the issues regarding companies that hide operating and financial liabilities behind lease agreements. It should increase transparency in lease accounting so that investors can get more accurate financial reports.
Companies need to be familiar with the new meaning of the term “lease” as defined in ASC 842. It is deemed to be a lease when businesses give customers the right to “control” the use of their assets for any given time in exchange for consideration. Control is existent when customers have the right to obtain substantially all of the economic benefits from and direct the use of an asset.
Aside from the broader definition of a lease, ASC 842 also compels companies to identify the lease and non-lease elements in all lease contracts. Below are the three measures necessary for an agreement to be considered as a lease agreement.
- Identified Asset
- Economic Benefit
- Direct Use of Asset
Scope of ASC 842
Companies shall apply the ASC 842 guidelines to all leases of property, plant, and equipment, including subleases of these assets. However, the following are exempted from using the lease accounting of ASC 842:
Leases of Intangible Assets
Intangible assets are those that do not have physical substance. Examples of intangible assets include the air-use rights, rights to use the space below the surface of the earth, or rights to any area inaccessible to or cannot be inhabited by people.
Leases to Explore for or Use Non-Regenerative Resources
ASC 842 has no control over leases for exploration or use of minerals, natural gas, oil, and other similar non-regenerative assets.
Leases of Biological Assets
Companies are not obliged to apply ASC 842 standards in leases of biological assets, including plants and animals.
Leases of Inventory
The following are some of the examples of inventories which are exempt from the ASC 842 guidelines:
1. Goods awaiting sale
2. Goods in process (currently under production)
3. Goods to be used in production (directly or indirectly), such as raw materials and supplies
Leases of Assets Under Construction
ASC 842 gives clear guidelines on how to treat the income from an asset that is still under construction. Income earned during construction shall be recognized as income.
Any lease that has a term of 12 months or less is deemed as “short-term,” thus not controlled by ASC 842.
Service Concession Arrangements
Service concession arrangements (as defined in ASC 853) are also exempt from ASC 842 control.
ASC 842 does not cover leveraged leases and shall apply guidelines stated in ASC 840, instead.
Just like ASC 840, ASC 842 standard still classifies lease into two groups. These are the Operating Lease and Finance or Capital Lease. These types of leases, with a term of more than 12 months, shall be reported in the financial statements of companies.
Operating Lease occurs when the lessor transfers the use of an asset to the lessee for a certain period of time, without transferring its control.
If the lessee obtains both the use and control of an underlying asset, it is classified as Finance Lease. The contract must meet any of the five criteria below to be classified as a finance lease.
1. Transfer of ownership of the underlying asset to the lessee by the end of the lease term.
2. There exists an option to purchase the underlying asset, which the lessee is reasonably sure to
3. The lease term is for a significant part of the underlying asset’s economic life (around 75%).
4. The sum of the lease payments and the present value of any residual value guaranteed by the
lessee exceeds the fair value of the underlying asset (around 90%).
5. The underlying asset has no alternative use to the lessor at the end of the lease term.
Accounting for Leases
The ultimate goal of ASC 842 is to have all the lease data and information be recorded in the financial statements of companies. ASC 842 requires businesses to account for the assets and liabilities of their leases and all lease procedures involved. In ASC 840, businesses only used to present financial leases, and include their operating leases in the notes of financial statements. These new lease guidelines have a significant effect on the accounting treatment of companies. With the ASC 842, almost all operating leases are now capitalized in the balance sheet. Thus, financial statements present an increase in assets and liabilities.
Lessees need to record both the lease liability and the right-of-use asset. On the other hand, lessors have to determine the type of lease used first. The accounting treatment to be used by lessors will depend on whether the contract is a financial or operating lease.
Modification and Remeasurement of a Lease
ASC 842 provides the guidelines for accounting treatment on modifications, terminations, and remeasurements of lease contracts. Remeasurements may also include reassessments, which are not considered as modifications.
Lease modification occurs when there is any change in the contractual terms and conditions, which was not part of the original contract. Such modification significantly changes the scope, consideration, or duration of the lease. Below are some of the conditions which may be modified after the commencement date of the lease contract.
- A lease extension
- An early lease termination
- A change in the timing of lease payments
- The lease of additional space in the same building
Lease modifications can be treated as a separate contract if the following two conditions exist:
- The lessee is granted an additional right of use which was not included in the original
- There is an increase in lease payment, which is comparable to the standalone price for
the additional right of use of the asset
On the other hand, a lessee may undergo contract remeasurement and reallocation if one of the factors below happens, under the ASC 842.
- Remeasurement of the lease liability
- Contract modification of the effective date, which is not accounted for as a separate contract.
Sales and Leaseback Transactions
A sale and leaseback transaction happens when a seller-lessee sells its owned-property to a buyer-lessor and leases back a portion or all of the same property. It is crucial to determine whether a sale happens in a sale and leaseback transaction. It will guide a company in using the appropriate accounting treatment for this purpose. The seller-lessee retains the use of its transferred asset (with consideration) through rental payments.
Benefits a Seller-Lessee Gets From a Sale and Leaseback Transaction
- Generates cash flows
- Transfers tax ownership and related tax benefits, resulting in lower refinances rate
- Reduces risk-exposures of asset owners
- Balance Sheet reflects less financing, as compared under a traditional mortgage
- Provides temporary transition space to a seller-lessee that needs to relocate to a new property.
Remember that Leveraged Leases only apply to lessors. Guidelines on leveraged leases use the ASC 840 standards, which were not incorporated in ASC 842. Instead, ASC 842 grandfathers the accounting of existing leveraged leases at their effective date. Thus, the lessor shall apply the ASC 840 guidelines on leveraged leases that commenced before the effective date of ASC 842. Under ASC 842, new lease contracts are not allowed to be accounted for as leveraged leases. Therefore, any new lease shall be accounted for as either operating or finance leases under the new standard.
Since lessees are not affected in this situation, they shall treat new leveraged leases like non-leveraged leases. Lessees are also expected to apply the transition guidelines to all their contracts upon the adoption of ASC 842.
Characteristics of Leveraged Leases:
- The lease term meets the criteria to be classified as a direct financing lease (according to ASC 840).
- There are at least three parties involved:
- The lessee
- The long-term creditor; and,
- The lessor
- The long-term credit financing is nonrecourse to the general credit of the lessor (considered as the equity investor), who should be provided with substantial leverage in the transaction.
- The lessor’s net investment declines and subsequently rises during the lease term.