Leasing Standards Under ASC 842: An Overview of Changes

As discussed in an earlier post, private companies who prepare financial statements in accordance with generally accepted accounting principles (GAAP) will soon be making big changes in lease reporting. Under the new standard (ASC 842), all leases for a period more than twelve months will have reporting requirements affecting the balance sheet and notes to the financial statements. There are several complex factors to consider as companies prepare for the transition; I’ve included a summary by lease classification of the large-scale changes affecting lessees. 

Changes in Lease Definition

In preparation for transition to ASC 842, a company should plan to review all its contracts – not just those titled “lease agreement.” This is specifically because the standard has changed the definition of a lease to include all contracts (in whole or in part) containing the right to control an identified asset for a given period in exchange for payment. Previously, emphasis was placed on delineation between capital and operating leases; this was specifically because capital leases were the only type affecting the balance sheet. However, now that  both types of leases will be accounted for on the balance sheet,  companies must determine whether new and existing contracts contain lease components. If contracts contain lease components, there must be a coinciding right-of-use asset and lease liability recorded.

Changes in Finance Leases

Finance leases, formerly known as capital leases, receive a comparatively minor update as companies transition to comply with ASC 842. Under previous reporting standard, these types of leases already recorded both a right-of-use asset and related lease liability.

To determine whether your company has any finance leases, review contracts and agreements with the following questions in mind:

• Will my company own the leased asset at the end of the lease’s term?
• Is there an option for my company to purchase the asset at the end of the lease term, and will my company take advantage of this option?
• Does the term of my company’s lease cover a large portion of the leased asset’s economic life?
• Do my company’s lease payments make up a substantial portion of the leased asset’s fair value?
• Is the asset being leased so specialized that it has no alternative use at the end of the lease term?

The first four questions probably feel familiar from the old standard, but you’ll notice the criteria are more principle-based rather than referencing specific percentages. Additionally, the last question was added by the new standard. 

If your response to any of the above questions is yes, then your company has a finance lease. If all questions can be answered “no,” your company may have an operating lease, as described in the following section.

Changes in Operating Leases

Operating lease reporting will experience the most significant change as companies pivot to conform to ASC 842. In fact, these types of leases are a primary reason for the transition. Formerly deemed off-balance sheet financing, payments related to operating leases have historically been accounted for exclusively on the income statement.  However, the new standard will require companies record right-of-use assets and lease liabilities on the balance sheet for operating leases. This helps identify a company’s future lease obligations more transparently.

Calculating Lease Liabilities and Right-of-Use Assets: What You’ll Need

No matter which type of lease you have, you’ll need to gather the same information in order to record the lease liabilities and assets. In preparation, you should gather the following:

• Lease agreements and other contracts containing lease components
  • The sum of payments to be made over the life of the lease
  • Be sure to separately identify payment for lease components compared to payment for non-lease components:
    • The former is included in the calculation of asset and liability balances
    • The latter are expensed as incurred.
    • The discount rate, as of the date of lease commencement
  • There are a few different rates a company can use, including
    • The rate implicit in the lease,
    • A company’s incremental borrowing rate, or
    • The risk-free rate.

Coming Soon

In  my next post,  I will go into detail about how to calculate the new right of use liabilities and assets. 

For additional considerations, please reach out to Carrie Ommen, CPA, , or contact our Business Solutions team at Mahoney to be of help to you in any way.