By Harry A. Steindler, CPA – Partner
What is ASC 842? – Summary
ASC 842, the new standard for U.S. generally accepted accounting principles (U.S. GAAP) lease accounting, requires all leases longer than 12 months to be recorded as assets and liabilities on a company’s balance sheet. The Financial Accounting Standards Board, or FASB, created this new standard to foster more transparency between companies and financial statement users.
ASC 842 is a replacement for the previous U.S. GAAP lease accounting standard, ASC 840, under which certain leases might have been classified as “operating leases” and therefore, not recorded on the balance sheet. As a result, they were excluded from many financial analysis ratios, such as return on assets, and these exclusions could give an investor or lender an incomplete understanding of a company’s performance.
Now, with ASC 842, all organizations that follow U.S. GAAP, are required to report the value and future obligations of leases on their balance sheets. Categorizing most long-term (greater than 12 months) leases as both liabilities and right-of-use assets.
ASC 842 Lease Accounting
With the adoption of ASC 842 comes significant impacts on the balance sheets of many companies. Even if an organization only has a single lease, it is often for real estate and, therefore, may have a significant impact on the financial statements. Of course, companies can, and do, lease far more than simply office space.
Leased assets may include computers, telephones, vehicles, heavy equipment, and warehouse space. Leases can also be embedded in service and usage contracts and can be hidden among other expenses.
Finding all these lease obligations and recategorizing them may prove challenging for many companies as they implement the new U.S. GAAP lease accounting standard. Without a doubt, ASC 842 lease accounting is a bit more complex than lease accounting under the previous lease standard.
ASC 842 Lease Calculation
Previously, under ASC 840, accounting for operating leases was easier than accounting for capital leases because lease payments were simply expensed on a straight-line basis. Under ASC 842, the present value of committed future payments must be recorded on the balance sheet as a lease liability, offset by a right-of-use asset. A capital lease under ASC 840 is similar to a finance lease under ASC 842, including the definition and calculations.
Entities that Must Comply with ASC 842
All entities that follow U.S. GAAP and have leases longer than 12 months in length must comply with the rules stated in ASC 842
When is ASC 842 Effective for Private Companies?
The ASC 842 effective date is December 15, 2021 (calendar 2022 year-ends and beyond). This effective date was delayed from the originally stated date to allow organizations accounting relief from other accounting standard changes and then due to the COVID-19 global pandemic.
An update to ASC 842 was announced by the FASB to provide relief in identifying discount rates. A discount rate is applied to future lease payments to determine the lease liability to be recorded on the balance sheet. Originally, ASC 842 required companies to select one discount rate calculation methodology for all leases. The relief granted by the FASB allows companies to choose the type of discount rate methodology by asset class.
This relief is important because it allows an organization to invest time calculating an incremental borrowing rate for large-value leases like office space, thereby reducing the lease liability while for smaller leases that are less material to the financial statements, an organization can simply use the appropriate risk-free rate.
Loan Agreement Covenant Considerations
Although ASC 842 characterizes operating lease liabilities as operating liabilities, rather than as debt, accounting under ASC 842 will still affect certain loan covenant calculations. If a company has significant debt subject to financial covenants, it would be prudent to have proactive conversations with lenders.
Conclusion
ASC 842 brings additional complexity to financial reporting under U.S. GAAP. FASB and others feel that the new standard will make financial statements more meaningful. We are ready to work with our clients to implement ASC 842 for the coming year-end. The transition to ASC 842 and related calculations can be challenging. At MichaelSilver, we are partnering with LeaseCrunch® Lease Accounting Software to help our clients move ASC 842 across the finish line. Please talk with your MichaelSilver contact at 847.982.0333 to find out how to move toward compliance as you plan for your year-end accounting and reporting. Thank you to our friends at LeaseCrunch® for supplying content for this article!
Harry A. Steindler, CPA – Partner, heads up our Client Accounting and Advisory Services Group. He focuses on providing tax and business advice and assurance services to closely held businesses and their owners, nonprofit organizations, and individuals. Harry grew his career in client service and firm leadership. serving as office managing partner, assurance managing partner, and head of a nonprofit assurance practice. For most of his career, Harry has been actively involved in human resource functions including recruiting, mentoring, and leadership development.
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