ASC 842 requires nearly all leases to be accounted for on balance sheet.
This requirement significantly differs from the legacy lease accounting in ASC 840, especially for lessees accounting for operating leases.
ASC 842 prescribes a dual model approach for lessees whereby a lease must be classified as either a finance lease or operating lease, using the classification test.
However, regardless of classification, all leases (other than those that qualify for the short-term lease practical expedient) are recognized on the balance sheet. As such, at commencement of a lease, a lessee recognizes an asset for its right to use the underlying asset and a liability for its lease obligation.
The subsequent accounting will differ depending upon the lease classification.
Similar to the FASB, the International Accounting Standards Board (IASB) issued its standard on lease accounting, IFRS 16, Leases, in 2016. While the FASB and IASB worked together jointly on these standards, a key difference is in the lessee accounting model. IFRS 16 has a single lessee accounting model. As with U.S. GAAP, nearly all leases under IFRS will be accounted for on balance sheet, however, instead of the two classifications for lessees, IFRS requires lessees to account for leases in a manner similar to finance lease accounting under ASC 842.
Identifying Contracts That Contain a Lease
Determining whether a contract is a lease or contains a lease is critical to correctly applying lease accounting. As we noted above, nearly all leases are required to be recorded on the balance sheet. So, a key risk is that if a lease contract is not appropriately identified, then it will not appropriately be reflected on the balance sheet.
ASC 842 defines a lease as:
A contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.
If you take a closer look at the definition, there are two key criteria that must be met for an arrangement to meet the definition of a lease:
- There must be an identified asset; and
- The lessee must have the right to control the use of the identified asset
Determining whether a contract is a lease or contains a lease must be done at inception of the contract based on this definition. It is not always black and white, so careful consideration of all contracts is important. For example, a service agreement or other contract that is not explicitly labeled as a lease agreement may contain an embedded lease which would need to be accounted for under ASC 842.
Key Concepts – Least Term, Lease Payments, and the Discount Rate
There are a number of key concepts relevant to lease accounting that are important to understand; The lease term, lease payments, and the lease discount rate are three of them applicable to both lessees and lessors. These are integral components to determining the lease liability and ROU asset, and therefore, critical to the accounting for leases.
The lease term represents the period of use for the asset, which is the period over which the lease payments will be recognized. Therefore, determining the right lease term will have a direct impact on the recorded lease assets and liabilities.
The lease term is not just the noncancelable term. Other factors must be evaluated such as optional renewal periods, periods after an optional termination date and lessor options to extend a lease. There is often judgment involved when determining the lease term.
Lease payments are the payments made by the lessee to the lessor for the right to use the underlying asset during the lease term and include the following:
Determining what is included in the lease payments is essential to determine lease classification, as well as the measurement of lease assets and liabilities.
Lease Discount Rate
The discount rate is important to accounting for leases as a discount rate is used to calculate the present value of the lease payments when:
- Determining lease classification,
- Measuring a lessee’s lease liability, and
- Measuring a lessor’s net investment in a lease for sales and direct financing leases
The discount rate used by a lessee should be the rate implicit in the lease unless that rate cannot be readily determined. In that case, the lessee uses its incremental borrowing rate. Lessees that are not public business entities are permitted to use a risk-free discount rate for the lease.
For a lessor, the discount rate for the lease is the rate implicit in the lease.
For additional informational videos on key lease accounting concepts, take a look at our YouTube channel and be sure to subscribe to stay updated as we add videos to the channel. For a more comprehensive understanding of these topics please see our Leases: Overview of ASC 842 course.
At the commencement date of a lease, the lessee calculates and records a lease liability and a right of use asset, as illustrated by the following diagram.
ASC 842 does provide targeted relief for short-term leases in the form of a practical expedient that can be elected by class of underlying asset. Short-term leases are defined as leases with a lease term of 12 months or less that do not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise. The practical expedient allows these leases to remain off the balance sheet.
Subsequent account depends on whether the lease is classified as a finance lease or an operating lease which is determined by applying the following lease classification test.
Since the lease liability is a discounted amount, it must be amortized using the effective interest method. In addition, lease payments will reduce the lease liability when they are paid. The ROU asset must also be reduced over the lease term. However, this expense recognition pattern is different for finance and operating leases. For finance leases, the lessee will amortize the ROU asset over the shorter of the lease term or the useful life of the ROU asset, usually on a straight-line basis. The goal of an operating lease is to present lease cost on a straight-line basis over the lease term. Since the effective interest method must be applied to the lease liability, thus resulting in expense that is higher in earlier periods of the lease than later periods, the only way to achieve this straight-line lease cost is to “plug” the amortization of the ROU asset to yield the desired result. There are two different methods to calculate this amount, however they arrive at the same answer. Our course, Leases: Lessee Accounting Explained provides worked examples of both methods as well as a comprehensive understanding of lessee accounting. Other subsequent lessee accounting considerations include impairment considerations for the right of use asset and income tax impacts.
The good news is that lessor accounting under ASC 842 is very similar to lessor accounting under legacy GAAP (ASC 840). However, the bad news is that lessor accounting can be somewhat complicated. Much of the guidance for identifying a lease, lease term and lease payments is similar for both lessors and lessees. Our Leases: Overview of ASC 842 course covers these concepts for both lessees and lessors. Lessors classify leases as sales-type, direct-financing, or operating based on the results of two interrelated classification tests. The accounting differs depending upon the classification. For example, for both sales-type and direct financing leases, the underlying asset is derecognized and a net investment in the lease is recognized at lease commencement. For operating leases, the underlying asset remains on the books of the lessor. ASC 842 provides guidance on the accounting for any selling profit or loss that arises for sales-type and direct-financing leases. One of the complicating issues with lessor accounting is the discount rate. Lessors will always use the rate implicit in the lease, however, there may be up to three variations of this rate used by lessors to accurately account for the lease. Our course Leases: Lessor Accounting Explained provides a comprehensive understanding of lessor accounting, including worked examples of the three types of leases.
Accounting for Changes After the Commencement Date
Change happens! Lease terms and agreements do not always remain the same throughout the original lease term. When changes take place after the commencement date, there are accounting implications and consequences.
ASC 842 provides guidance on when a contract should be reassessed and when changes require a remeasurement of the lease liability and the ROU asset during the term of the lease.
There is also specific guidance for accounting for a lease modification, which is defined as a change to the terms and conditions of a contract that results in a change in the scope of or the consideration for a lease (for example, a change to the terms and conditions of the contract that adds or terminates the right to use one or more underlying assets or extends or shortens the contractual lease term).
When lease modifications takes place, lessees and lessors must determine whether the modified lease should be accounted for as a separate contract or not based on whether:
- The modification grants the lessee an additional right-of-use that was not included in the original lease; and
- The lease payments are priced commensurate with the stand-alone price of the additional right-of-use, adjusted for the circumstances of the contract
These two criteria indicate that the lessee and the lessor essentially entered into a new arms-length transaction that was not tied to or dependent on the existing contract. As such, if both the conditions are met, then the modification is accounted for as a separate contract.
Our course, Leases: Changes After The Commencement Date provides an in-depth look at this guidance.
ASC 842 provides guidance on other specific lease accounting considerations such as contract combinations, separating components of a contract, accounting for initial direct costs of a lease, sale-leaseback transactions, sublease arrangements, and many more!
Lease Presentation and Disclosure
One of the key goals of ASC 842 is to ensure greater transparency in financial reporting by providing a more faithful representation of the rights and obligations arising from leases. To meet this goal, certain presentation and disclosure requirements must be followed.
A lessee must present right-of-use assets and lease liabilities separately for finance leases and operating leases, either on the balance sheet or disclosed in the notes. For finance leases, right of use asset amortization is presented consistent with depreciation or amortization of similar assets. Interest expense is presented for the amortization of the lease liability. For operating leases, a single lease expense is presented in the income statement as an operating expense. A lessor must present lease assets (that is, the aggregate of the lessor’s net investment in sales-type leases and direct financing leases) separately from other assets in the statement of financial position.
To further the objective for entities to provide information about leases that enable users of financial statements to assess the amount, timing, AND uncertainty of cash flows arising from leases, ASC 842 has some extensive disclosure requirements.
With both quantitative and qualitative disclosures required, you can expect that the more leasing transactions an entity has, the more extensive and comprehensive disclosures must be to meet the needs of their financial statement users.
For a review of lease disclosures for both lessees and lessors, refer to our lease disclosure blog post.
Accounting Differences: ASC 842 vs. IFRS 16
While ASC 842 and IFRS 16 were developed as part of a joint project between the FASB and IASB, there were some critical areas that the Boards did not agree on. As such, while there are many similarities in the standards, there are also differences.
Some of the key differences are:
Lessee Accounting Model - Dual Model vs Single Model
As discussed above, ASC 842 has a dual model approach for lessee accounting, classifying a lease as either a finance lease or an operating lease which impacts the subsequent accounting. The IASB, on the other hand, went with a single model approach for lessee accounting under IFRS 16 with most leases generally accounted for similar to a finance lease under ASC 842.
For further discussion on differences in lessee classification of leases and the subsequent accounting under ASC 842 versus IFRS 16, refer to the following blog – New Lease Accounting Standards For Lessees: ASC Topic 842 & IFRS 16.
Low Value Exemption
IFRS 16 includes an exemption for leases of low-value assets. Instead of recognition on the balance sheet, a lessee may elect to recognize lease payments on a straight-line basis over the lease term. This exemption can be elected on a lease-by-lease basis. There is no such exemption under U.S. GAAP.
Timing of Determining the Discount Rate
Under ASC 842, both lessees and lessors must determine the discount rate at the lease commencement date.
Under IFRS 16, lessees must determine the discount rate at lease commencement, however, lessors determine the rate implicit in the lease at the lease inception date.
The lease commencement date is the date on which a lessor makes an underlying asset available for use by a lessee. The lease inception date may be different than the lease commencement date. For example, there could be a period of time between the inception date of a lease and when the leased asset is made available, for example, if certain improvements need to be done to the asset before lease commencement.
Index-Based Variable Lease Payments
Variable lease payments are payments made by a lessee to a lessor for the right to use an underlying asset that vary because of changes in facts or circumstances occurring after the commence date, other than the passage of time.
When an index-based variable payment adjusts due to a change in the index, IFRS 16 requires a lessee to remeasure the lease liability on the date when the adjustment to the lease payment takes effect. Under U.S. GAAP, remeasurement is not required. Rather, under ASC 842, changes to index or rate-based variable lease payments are recognized in the income statement in the period of the change.
Sale and Leaseback Accounting
In a sale and leaseback transaction, the sale criteria in ASC 606, Revenue from Contracts with Customers, for U.S. GAAP and IFRS 15, Revenue from Contracts with Customers, for IFRS must be met to recognize a sale.
Under ASC 842, a seller-lessee recognizes a gain or loss for the difference between the sales proceeds and the carrying amount of underlying asset.
Under IFRS 16, a seller-lessee recognizes a gain or loss for only the difference related to the right transferred to the buyer-lessor.
Join the Revolution with GAAP Dynamics!
GAAP Dynamics training courses are designed to help leading accounting firms and multinational companies move beyond the training status quo. Our courses are continually updated and new courses are constantly being added, so check back often! Below are a few of our courses related to leases.
Leases: Overview of ASC 842 - This eLearning course provides an overview of the requirements of ASC 842 Leases for both lessees and lessors, including identifying embedded leases, determining the key inputs, and classifying leases as either operating or financing.
Leases: Lessee Accounting Explained - Explore the accounting for leases (ASC 842) from the lessee’s perspective in this interactive, fun & example-based eLearning course!
Leases: Lessor Accounting Explained - Explore the accounting for leases (ASC 842) from the lessor's perspective in this example-based eLearning course.
Leases: Changes After The Commencement Date - This eLearning course covers the accounting for changes that occur after the commencement date, including modifications to the lease agreement, reassessment of the key terms of the contract, and remeasurement of the ROU asset and lease liability.
There are numerous resources available on accounting for leases under both ASC 842 and IFRS 16. To save you time searching, we have compiled a list of resources below to assist you in your research and quest to master lease accounting.
Resources from GAAP Dynamics:
We have written several blogs on a variety of lease accounting topics which are categorized and listed below. Click on the links to view the full blog post.
ASC 842 - Overview and Transition
Top 5 Biggest Changes With The New Lease Accounting Standard (ASC 842)
ASC 842 is a big deal! How big? This post describes the top five biggest changes companies face as a result of implementing the new leasing standard.
New Lease Accounting Standards For Lessees: ASC Topic 842 & IFRS 16
This blog post captures the similarities and differences between the new lease accounting standards (ASC 842 and IFRS 16) for lessees.
New Lease Accounting Standard (ASC 842): Blowing Up The Balance Sheet
Let’s take a look at another of the biggest changes coming from ASC 842 -- Blowing up the Balance Sheet.
New Lease Accounting Standards For Lessors: ASC topic 842 & IFRS 16
This blog post captures some of the similarities and differences between the new lease accounting standards (ASC 842 and IFRS 16) for lessors.
Transition Relief For Entities Adopting ASC 842
Transitioning from ASC 840 to ASC 842 is proving to be time consuming and difficult; however, the FASB has issued a recent ASU providing relief.
Lease Accounting Key Concepts
Is It A Lease? It Matters When Moving From ASC 840 To ASC 842
This blog post dives into one of the challenges of applying ASC 842, determining whether or not an arrangement meets the definition of a lease.
Determining The Lease Term Under ASC 842
One of the key concepts in accounting for leases under ASC 842 is the lease term. In this blog, we explore how the lease term is determined.
Lease Payments: What's Included Under ASC 842 Differs From ASC 840
To appropriately apply ASC 842, you must determine what is included in the lease payments. In this post, we take a look at what comprises the lease payments and why it is important.
Rates, Rates, And More Rates - Lessor Accounting Under ASC 842
What discount rate should a lessor use under ASC 842? This post walks you through the guidance.
Clarification of Lessee Discount Rates For Leases Under ASC 842
This post explores whether lessees should use the rate implicit in the lease or their incremental borrowing rate when applying ASC 842 to leases.
Sale and Leaseback Accounting
Sale and Leaseback Accounting: Moving From ASC 840 To ASC 842
Sale and leaseback accounting is changing under ASC 842! As you’ll see in this post, the guidance under ASC 842 is a lot different from ASC!
Gain Recognition On Sale And Leaseback Transactions Under ASC 842?
Before recording a gain on a sale and leaseback transaction under ASC 842, check out these 5 “red flags” that might cause a failed sale and leaseback.
Taxes and Lease Accounting
New Lease Accounting Standard (ASC 842 and IFRS 16): CAM and Taxes
This post discusses the accounting for common area maintenance charges (CAM) and property taxes under the new lease accounting standard (ASC 842 and IFRS).
Taxes And The New Lease Accounting Standard (ASC 842)
Entities are getting ready to implement ASC 842, but how are tax accounts and returns impacted? This post explores the tax impacts of the new lease accounting standard.
Other Accounting for Leases Issues
Lease Disclosures: Stepping It Up From ASC 840 To ASC 842
The disclosure requirements under current U.S. GAAP for leases (ASC 840) aren’t terribly insightful, but this is about to change under the new lease accounting standard (ASC 842).
Land Easements Under The New Lease Accounting Standard (ASC 842)
This post explores ASU 2018-01, which provides clarification for the accounting for land easements under the new lease accounting standard, ASC 842.
Why Is Everybody Freaking Out About Embedded Leases? (ASC 842)
Identifying embedded leases is cited as a significant challenge in implementing the new leases standard (ASC 842). This post welcomes all into the light!
Capacity Lease Agreement: Is It A Lease Under 842?
When is a “lease” of capacity considered a lease under the new lease accounting standard (ASC 842)? This post explores the judgments that needs to be considered.
Accounting For Initial Direct Costs Under ASC 842
How do you account for the initial direct costs of obtaining a lease under ASC 842? Read this post to find out.
IFRS 16 VS ASC 842: How To Account For Low-Value Leases
As preparers brace to implement ASC 842 and recover from implementing IFRS 16, let’s take a look at a common issue preparers face: low-value leases.
Q&A From ASC 842 Leases: An Introduction To Lessee Accounting Webinar
Missed our webinar? See what peers are asking with this Q&A recap from our webinar on Lessee Accounting under ASC 842.
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Resources From the FASB and IASB:
- ASC 842, Leases – This link will take you to the authoritative guidance (professional subscription required).
- Leases Project Page– The FASB Lease Project page is a good starting point for the various resources provided by the FASB.
- Leases Educational Resources– This page provides links to the original ASU, any updates related to the ASU, and various publications and videos produced by the FASB to help financial statement preparers implement the new standard.
- IFRS 16 Leases– This link will take you to the authoritative guidance (professional subscription required).
Resources From Accounting Firms:
The Big 4 accounting firms have informative, in-depth guides on Lease Accounting. To save you time and effort in your research, we have linked to them below.
- KPMG Leases Handbook
- EY Financial Reporting Developments – Lease Accounting
- PWC’s Lease Accounting Guide
- Deloitte’s A Roadmap to Applying the New Leasing Standard