lease 842

Understanding Lease 842

Lease 842, also known as ASC 842, is a new lease accounting standard issued by the Financial Accounting Standards Board (FASB). This standard supersedes the previous lease accounting rules under ASC 840 and introduces significant changes in how companies must recognize, measure, present, and disclose leases in their financial statements. ASC 842 aims to increase transparency and comparability by requiring companies to recognize lease assets and liabilities on their balance sheets.

Key Changes Under ASC 842

One of the most significant changes under ASC 842 is the requirement for lessees to recognize a right-of-use (ROU) asset and a lease liability for almost all leases, including operating leases. Under the previous standard, operating leases were off-balance-sheet transactions, meaning that companies did not have to report them as liabilities. This change increases the visibility of a company's leasing activities and its financial obligations.
The standard distinguishes between finance leases (formerly capital leases) and operating leases. However, the accounting treatment for lessees is similar in both cases: recognition of an ROU asset and a lease liability on the balance sheet. The difference lies in the pattern of expense recognition in the income statement.

Lease Classification

Lease classification under ASC 842 determines the pattern of expense recognition. A lease is classified as a finance lease if it meets any of the following criteria:

1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
   

1. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
   

1. The lease term is for the major part of the remaining economic life of the underlying asset.
   

1. The present value of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the underlying asset.
   

1. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
   

If none of these criteria are met, the lease is classified as an operating lease.

Initial Recognition and Measurement

Upon the commencement date of the lease, a lessee must recognize an ROU asset and a lease liability. The lease liability is measured at the present value of the lease payments to be made over the lease term, discounted using the interest rate implicit in the lease or, if that rate cannot be readily determined, the lessee's incremental borrowing rate.
Lease payments include:

1. Fixed payments, including in-substance fixed payments, less any lease incentives.
   

1. Variable lease payments that depend on an index or rate.
   

1. Amounts expected to be payable under residual value guarantees.
   

1. The exercise price of a purchase option if the lessee is reasonably certain to exercise that option.
   

1. Payments for penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease.
   

The ROU asset is initially measured at the amount of the lease liability, adjusted for any lease payments made at or before the commencement date, less any lease incentives received, plus any initial direct costs incurred by the lessee, and an estimate of costs to be incurred by the lessee to dismantle and remove the underlying asset, restore the site on which it is located, or restore the underlying asset to the condition required by the terms and conditions of the lease.

Subsequent Measurement

After the commencement date, the lessee measures the lease liability at the amortized cost using the effective interest method. The ROU asset is generally measured at cost, less any accumulated amortization and accumulated impairment losses, and adjusted for any remeasurement of the lease liability.
For finance leases, the lessee recognizes interest on the lease liability separately from the amortization of the ROU asset. For operating leases, the lessee recognizes a single lease cost, calculated so that the remaining cost of the lease is allocated over the remaining lease term on a straight-line basis.

Lease Modifications

Lease modifications are changes to the terms and conditions of a contract that result in a change in the scope of or the consideration for a lease. A modification is accounted for as a separate lease if it grants the lessee an additional right-of-use not included in the original lease, and the lease payments increase commensurate with the standalone price for the additional right-of-use.
If a modification is not accounted for as a separate lease, the lessee must remeasure the lease liability using a discount rate determined at the effective date of the modification. The lessee adjusts the ROU asset by the amount of the remeasurement of the lease liability. If the carrying amount of the ROU asset is reduced to zero, any remaining amount of the remeasurement is recognized in profit or loss.

Transition and Practical Expedients

The transition to ASC 842 can be complex, and the FASB has provided several practical expedients to ease the transition. These include:

1. The Package of Practical Expedients: Lessees may elect not to reassess whether existing contracts contain leases, the lease classification of existing leases, and initial direct costs for existing leases.
   

1. The Hindsight Practical Expedient: Lessees may use hindsight in determining the lease term and assessing impairment of ROU assets.
   

1. The Land Easement Practical Expedient: Lessees are not required to assess whether existing or expired land easements that were not previously accounted for as leases under ASC 840 are or contain leases under ASC 842.
   

Entities must apply ASC 842 using a modified retrospective approach, recognizing a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption.

Disclosure Requirements

ASC 842 requires enhanced disclosures to provide financial statement users with sufficient information to assess the amount, timing, and uncertainty of cash flows arising from leases. Lessees must disclose quantitative and qualitative information about their leasing activities, including:

1. Information about the nature of leases, including a general description of the lease, the basis and terms and conditions on which variable lease payments are determined, and the existence and terms and conditions of options to extend or terminate the lease.
   

1. Information about leases that have not yet commenced but that create significant rights and obligations for the lessee.
   

1. Information about significant judgments and assumptions made in applying the lease accounting requirements.
   

1. Information about the cost of leases for the period, segregated between finance and operating leases.
   

1. A maturity analysis of lease liabilities, showing the undiscounted cash flows on an annual basis for a minimum of each of the first five years and a total for the remaining years.
   

Impact on Financial Statements

The implementation of ASC 842 has a significant impact on the financial statements of lessees. It changes the presentation of the balance sheet, the income statement, and the statement of cash flows.
On the balance sheet, lessees will see an increase in assets and liabilities due to the recognition of ROU assets and lease liabilities. This change can affect financial ratios, such as the debt-to-equity ratio, which can have implications for loan covenants and other contractual arrangements.
On the income statement, finance leases result in the recognition of interest expense on the lease liability and amortization expense on the ROU asset. Operating leases result in a single lease expense, typically recognized on a straight-line basis over the lease term.
On the statement of cash flows, finance lease payments are classified as financing outflows (for the repayment of the principal portion of the lease liability) and operating outflows (for the interest portion). Operating lease payments are classified as operating outflows.

Implementation Challenges

Implementing ASC 842 can be challenging for many organizations, particularly those with a large number of leases. Some of the key challenges include:

1. Identifying All Leases: Companies must identify all lease agreements, which can be time-consuming and complex, especially for organizations with decentralized operations or a high volume of contracts.
   

1. Data Collection and Management: Companies need to gather detailed data about each lease, including lease terms, payment schedules, and discount rates. This data must be maintained and updated throughout the lease term.
   

1. Systems and Processes: Existing accounting systems and processes may need to be modified or replaced to accommodate the new lease accounting requirements. This may involve significant investment in new software and training for accounting staff.
   

1. Judgment and Estimates: ASC 842 requires significant judgment in areas such as determining the lease term, assessing the likelihood of exercising renewal or purchase options, and estimating variable lease payments.
   

Conclusion

ASC 842 represents a major shift in lease accounting, with significant implications for lessees' financial statements and operational processes. By requiring the recognition of ROU assets and lease liabilities, the standard increases transparency and comparability of financial information. However, the implementation of ASC 842 also presents challenges, including identifying leases, collecting and managing data, and updating systems and processes. Organizations must carefully plan and execute their transition to the new standard to ensure compliance and minimize disruptions to their operations. As companies continue to adapt to ASC 842, ongoing education and training will be essential to navigate the complexities of lease accounting and leverage the benefits of increased transparency and improved financial reporting.