The Basics of Lease Accounting - ASC 842

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The implementation of Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 842 is one of the most significant changes in accounting in recent history.  This codification replaces Generally Accepted Accounting Principles (GAAP) ASC 840. This standard went into effect January 1, 2019, for public companies, certain not-for-profit companies, and employee benefit plans.  Both lessees and lessors are affected by ASC 842; however, there are many more changes for lessees to implement with this new standard.    

The most significant change to lease accounting with the new standard is the requirement of lessees to recognize Right-Of-Use (ROU) assets and liabilities for most leases.  This recognition requires lessees to record ROU assets and liabilities on their balance sheets. With the implementation of ASC 842, many of the previous operating leases (excluding short-term leases) will be considered ROU assets and liabilities that are required to be recorded on the balance sheet, which will significantly affect many of the financial ratios a company uses for financial reporting.    

Under ASC 842, a contract is a lease if the contract gives the customer the right to control the use of identified property, plant or equipment for a period of time in exchange for consideration.  A customer is considered to have control of identified property, plant or equipment if (1) the right to obtain substantially all of the economic benefits from the use of an identified asset and (2) the right to direct the use of the identified asset.  A contract must be evaluated at inception to determine if it contains a lease. Additionally, it must be re-evaluated at each modification.  

Many contracts contain both lease and non-lease components for different underlying assets.  The right to use an underlying asset (step 2 above) is considered a separate lease component if (1) a lessee can benefit from the use of the underlying asset either on its own or with other resources that are readily available and (2) the underlying asset is not highly dependent or highly interrelated with other assets in the arrangement.  Lessees can elect to separate lease and non-lease components or they can consider them together as a lease for reporting, which would increase the amount of the lease liability recorded on the balance sheet. Lessors can make the same election, although there is additional revenue guidance from ASC 606.  

There are significant financial statement presentation changes with the implementation of ASC 842. A modified retrospective transition approach must be followed for the preparation of comparative financial statements back to years beginning January 1, 2017.  This approach maximizes the comparability of financial statements while minimizing the complexity of the transition to the new lease standard. Within this approach, companies can also choose between two implementation methods. In addition to the changes on the balance sheet, the lease disclosure requirements in the notes to the financial statements are expanded for both lessees and lessors and require a new level of detail in comparison to the previous required disclosures.