What is FASB Topic 842?
FASB topic 842, or ASC 842, refers to the new lease accounting guidance, Accounting Standard Codification 842 for Leases. The newly-published lease accounting standard for US public companies and private companies issuing GAAP statements. Under the new standard, the key changes include the classification of leases, operating leases being recognized on the balance sheet, and additional disclosures in the financials.
What is a lease under ASC 842?
ASC 842 defines leases as contracts, or portions of contracts, granting “control” of an identifiable asset for a specific period of time in exchange for payment. The term “control” carries a distinct meaning in this definition. To demonstrate control of an asset, a business entity must be able to obtain “substantially all” of the economic benefit from the asset’s use and direct its use throughout the period of the contract.
What is the Effective Date?
For public companies, the FASB standard was effective for reporting periods beginning subsequent to December 15, 2018. For calendar year-end companies, this means the standard was adopted on January 1, 2019. ASC 842 is effective for the annual reporting periods of private companies and nonprofit organizations beginning after December 15, 2021. This means many private companies and non-profit organizations are working through the lease accounting transition for the 2022 year-end.
Scope of ASC 842: What’s covered and what’s not covered?
ASC 842 applies to most leases and subleases, but exceptions do exist. On occasion, a contract contains a lease, but it’s out of the scope of Topic 842 and the guidance should not be applied to the transaction. Here are the out-of-scope lease types, as detailed in Subtopic 842-10-15-1:
- Leases of intangible assets, such as cloud computing arrangements. The guidance for these agreements can be found in ASC 350, Intangibles – Goodwill and Other.
- Leases for the exploration or use of non-regenerative natural resources such as oil, natural gas, and minerals are covered under ASC 930, Extractive Activities – Mining, and ASC 932, Extractive Activities – Oil and Gas.
- Leases of biological assets such as plants, animals, and timber. These are addressed in ASC 905, Agriculture.
- Leases of inventory, which are covered under ASC 330, Inventory.
- Leases of assets that are under construction. These are addressed in ASC 360, Property, Plant, and Equipment.
Lessee accounting under ASC 842
Similar to ASC 840, the prior lease accounting standard, ASC 842 uses a two-model approach for lessees; each lease is classified as either a finance lease or an operating lease. This applies to all leased asset categories covered under the standard, including leases of equipment and real estate. “Finance lease” is a new term and replaces the term, “capital lease,” used under Topic 840. Additionally, ASC 842 changes the criteria defining a finance/capital lease.
Lessees reporting under Topic 842 are required to recognize both the assets and the liabilities arising from their leases. The lease liability is measured as the present value of lease payments, while the lease asset is equal to the lease liability adjusted for certain items like prepaid rent, initial direct costs, and lease incentives.
Among the many changes to lease accounting under this standard, the most significant is operating leases will be recorded on the balance sheet as lease assets and lease liabilities. The asset is known as the right-of-use asset, or ROU asset, and represents the lessee’s right to use the underlying asset while the lease liability represents the lessee’s financial obligation over the lease term.
For leases with terms of 12 months or less, ASC 842 allows an exemption and lessees can elect not to recognize lease assets and lease liabilities for short-term leases. For simplicity, LeaseGuru does not support short-term leases at this time.
Existing capital leases will not require adjustment or remeasurement upon transition, but they will be referred to as finance leases.
Operating lease accounting under ASC 842 - Example
When accounting for an operating lease, the lessee must:
- Recognize a single lease cost allocated over the lease term, generally on a straight-line basis
- Classify all cash payments within operating activities on the statement of cash flows
Below is an example of the accounting for an operating lease beginning post-transition. For the example, let’s assume the following facts:
- Payment terms: $20,000 annually, at the beginning of the period
- Start Date: 1/1/2023
- End Date: 12/31/2026
- Incremental Borrowing Rate (IBR): 3%
- The lessee determines this is an operating lease
Based on these circumstances, the present value of 4 annual payments of $20,000, made in advance, with a 3% IBR is $76,572*. The annual operating lease expense is $20,000, or the straight-line treatment of 4 annual payments with no escalations, rent holidays, etc. The amortization schedule for this lease is below.
*Note: The present value amount above ($76,572) is a simplified calculation based on Excel for illustrative purposes. The number you get should be lower than this, if you were using more accurate interest calculations, like those available in some lease accounting software solutions.
The entry to record the lease upon its commencement is a debit to ROU asset and a credit to lease liability:
Subsequent entries follow the amounts set forth in the amortization table. The entry for the annual activity of 2023 is below.
Finance lease accounting under ASC 842 - Example
When accounting for finance leases, lessees must:
- Recognize interest on the lease liability and amortization of the ROU asset in separate line items of the income statement
- Classify payments of the principal portion of the lease liability within financing activities and payments of interest on the lease liability within operating activities on the statement of cash flows
Per the guidance, existing capital leases will not require adjustment or remeasurement upon transition, provided they were accounted for correctly under ASC 840. Therefore the accounting treatment of a capital/finance lease beginning pre-transition will be the same as the accounting required post-transition and no transition accounting adjustments will be necessary.
However, one exception is if any deferred or prepaid rents associated with the capital/finance lease exist at transition. Any remaining balances of deferred or prepaid rents become adjustments to the related ROU asset.
We’ve detailed a full example of a finance lease beginning post-transition in another article, “Capital Lease Accounting and Finance Lease Accounting: A Full Example.”