ASC 842 is the lease accounting standard issued by the Financial Accounting Standards Board (FASB) that regulates how organizations record the financial implications of their lease agreements. ASC 842 requires all business entities, whether public, private or nonprofit, to record most lease arrangements to their balance sheets.
The ASC 842 effective date was staggered. Public companies adopted the standard after December 15, 2018. For private companies and nonprofits, the standard became effective after December 15, 2021. Several updates have since been issued, with the most recent as of this writing being ASU 2023-01 in March 2023. While the standard is no longer new, businesses must ensure that they maintain compliant practices, especially as they enter new leases or inherit new leases from a transaction.
Who is Required to Adopt the ASC 842 Lease Accounting Standard?
For compliance purposes, a lease is a legal contract (or any part thereof) that sets out terms under which one entity can control or use the assets of another in exchange for some consideration or payment. ASC 842 makes lease accounting disclosures part of compliance protocol.
For companies following US GAAP, compliance with ASC 842 is mandatory. It provides investors and stakeholders with a more transparent view of a company’s lease obligations.
The Scope of ASC 842: What Assets Does the Standard Apply to?
The scope of ASC 842 is wide, covering leases of any equipment, plant or property. In other words, it applies to most leases, including real estate, construction and production equipment and vehicles.
ASC 842 does not apply to intangible assets like goodwill, IP or right to explore. Nor does it apply to leases of biological assets (e.g. animals and plants), inventory or to assets currently under construction.
New Lease Classifications: Finance vs. Operating Leases
For lessees, leases are now classified as either finance leases (formerly capital leases) or operating leases.
- Finance leases record the leased asset as if it were an owned asset. These are often long-term contracts, usually where the lessee pays the fair value of the asset or uses it for the majority of its useful life.
- Operating leases work more like rental agreements, where ownership is not transferred to the lessee. Under ASC 842, operating leases are no longer off-balance sheet transactions.
Lessor accounting requirements remain substantially unchanged, whether lessors are using operating, sales-type or direct-financing leases. The leveraged lease was eliminated under ASC 842.
In sale-leaseback contracts, the lessee sells the asset to the lessor, then leases it back from them. The ASC 606 revenue recognition standard determines whether the transaction is considered a sale or a lease. If it’s determined to be a lease, ASC 842 applies.
Lease Accounting Disclosures
ASC 842 materially expanded disclosure requirements, adding an overall disclosure objective as well as enhanced specific disclosure and presentation requirements. Most of the new requirements pertain to lessees.
Lessee Obligations
For both finance and operating leases, lessees are now required to identify a right-of-use (ROU) asset and lease liability both on their balance sheets and in their lease accounting disclosures.
- The ROU recognizes the lessee’s right to use the leased asset.
- The lease liability represents the lessee’s obligation to make lease payments.
Lessees must also separately present ROU assets and liabilities for both operating and finance leases on the company’s income statement and cash flow statement.
Lessor Obligations
Lessor obligations have also increased, including separating the presentation of assets for operating leases and direct financing/sales-type leases on the balance sheet, income statement and cash flow statement.
There are also enhanced overall reporting requirements including:
- Disclosures of all lease arrangements
- Complete description of any judgments made
- Analysis of lease terms and discount rates
For the complete slate of changes and explanations, see the full text of the FASB update.
Recent Updates to the ASC 842 Lease Accounting Standard
Businesses that have adopted the lease accounting standard are obligated to monitor potential updates to ASC 842 and proactively assess how proposed updates can impact their financial statements.
The Financial Accounting Standards Board (FASB) recently issued Accounting Standards Update (ASU) 2023-01, which clarifies the guidance on leases between entities under common control. Common control exists when the same parent company or individual owns or controls both the lessor and the lessee.
ASU 2023-01 states that leases between entities under common control should be accounted for based on their legally enforceable terms and conditions, just like leases between unrelated parties. If the lease terms don’t reflect market conditions, the lessee should account for the lease as if it were a transfer of the right to use the asset directly from the parent company or controlling entity.
The effective date for ASU 2023-01 is fiscal years beginning after December 15, 2023, for public companies and fiscal years beginning after December 15, 2024, for private companies and nonprofit organizations. Early adoption is permitted.
Best Practices for Continued Lease Accounting Compliance
Meeting the current reporting obligations requires thorough due diligence.
- Maintain accuracy: Some lease contracts may contain both lease and non-lease provisions. Check that all the data in each contract is accurate and complete, including key terms, payment schedules and renewal options.
- Monitor and reassess: Some leases contain provisions that change over time. Those changes can impact ASC 842 compliance. Regularly monitor leases for any such changes, to properly reassess key estimates and judgments.
- Stay alert: Be aware of lease accounting standard updates and create a plan for adoption ahead of time.
Compliance With New Leases
Now that ASC 842 and ASU 2023-01 are in effect, businesses must ensure each new lease contract adheres to ASC 842’s reporting and presentation standards.
During the phase of contract negotiation, carefully review and negotiate each lease condition and term to understand their implications under ASC 842. Pay particular attention to clauses that might impact how a lease is classified, including purchase options, renewal options and variable lease payments.
Lessees must classify each new lease as either a finance or operating lease. The classification will have implications for balance sheet recognition, income statement presentation and cash flow reporting. Accurately measure and recognize ROU assets and liabilities and ensure all disclosures are properly detailed.
Maintaining ASC 842 Compliance During an M&A
ASC 842 also has implications for mergers and acquisitions. Due diligence during the M&A process now requires a comprehensive inventory of all contracts, including those held by the target business.
Each contract must be reviewed for precision and variable clauses must be monitored and assessed for changes over time. Once accuracy is ensured, integrate and harmonize all lease accounting practices and journal entry procedures to ensure a seamless workflow. Determine the fair value of each lease contract or provision and make any necessary adjustments
Foster Ongoing Diligence
Maintaining ASC 842 compliance requires implementing procedures and processes to ensure due diligence, along with continual monitoring and assessment of lease contracts. Most importantly, businesses must stay informed and proactive. Ensuring lease accounting compliance requires ongoing awareness and education.
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