Lease Accounting Under GAAP: A Quick Overview of ASC 842

For years, under the old lease accounting standard (ASC 840), the accounting for leases was relatively straightforward since most leases were classified as operating leases. Under the old standard, operating leases were kept off the balance sheet and lease payments were simply expensed as incurred.

However, the release of the updated lease accounting standard, ASC 842, in 2016 changed the game. The most notable shift is the requirement to recognize a “right-of-use asset” and “lease liability” on the balance sheet for virtually all leases exceeding 12 months. This update provides greater transparency into an entity’s financial commitments, a significant step in enhancing financial reporting.

When it comes to assessing a business's financial health, the saying “cash is king” holds true. Leases often provide an alternative to substantial cash outflows for purchasing assets. By mitigating costs associated with down payments, repairs, maintenance, asset obsolescence, and disposal, leasing arrangements have become a practical solution for many businesses.

Let’s explore the key principles of lease accounting under ASC 842 and how they impact your financial reporting.

Key Principles of Lease Accounting Under ASC 842

Lease Classification: Operating vs. Finance Leases

‍Similar to the prior standard, ASC 842 requires an analysis to determine whether a lease is classified as an operating lease or a finance lease (formerly known as a capital lease). A lease is classified as a finance lease if it meets any of the following five conditions:

1. Ownership Transfer: The asset ownership transfers to the lessee by the end of the lease term.
2. Purchase Option: The lease includes a purchase option reasonably certain to be exercised.
3. Lease Term: The lease term covers a significant portion of the asset's remaining economic life (typically 75% or more).
4. Present Value: The present value of lease payments equals or exceeds substantially all of the asset's fair value (generally a 90% threshold).
5. No Alternative Use: The leased asset has no alternative use to the lessor at the end of the lease term.

If none of these conditions are met, the lease is classified as an operating lease.

Balance Sheet Recognition

‍ASC 842 mandates that all leases with terms greater than 12 months must be recognized on the balance sheet. This includes:

• A lease liability, representing the present value of future lease payments.
• A right-of-use asset, representing the lessee’s right to use the asset during the lease term.

This shift ensures financial statement users have a clearer picture of an entity’s future obligations and the economic benefits derived from its lease arrangements.

Determining Lease Liability and Right-of-Use Asset

‍To calculate the initial recognition amount for both the lease liability and right-of-use asset, three inputs are essential:

1. Lease Payments: Fixed payments over the lease term.
2. Lease Term: Includes non-cancelable periods, renewal options likely to be exercised, and periods under lessor control.
3. Discount Rate: Either the rate implicit in the lease (if known) or the lessee's incremental borrowing rate.

For private companies, ASC 842 also allows the use of the risk-free rate, simplifying the calculation process.

Additional Considerations

Lease Term

‍ASC 842 provides clearer guidance for determining the lease term:

• It includes non-cancelable periods and renewal options reasonably certain to be exercised.
• Termination options likely not to be exercised are also factored in.

This expanded definition ensures the lease term reflects the full extent of the lessee's commitment.

Discount Rate

‍The discount rate can significantly impact the measurement of lease liability:

• If the rate implicit in the lease is unknown, the incremental borrowing rate is used.
• For private companies, the risk-free rate is often chosen as a simpler alternative.

ASC 842 has added complexity to lease accounting, particularly for small business owners navigating the initial recognition of right-of-use assets and lease liabilities. Determining lease classification, calculating the present value of lease payments, and allocating expenses require careful analysis and judgment.

If you have questions or need guidance implementing ASC 842 for your business, our team is here to help. Let us simplify the process and ensure compliance with these standards, so your business can focus on growth and success.

If you have any questions or need assistance implementing ASC 842 for your small business, please do not hesitate to reach out. We are here to ensure that your company complies with all applicable accounting standards and continues to thrive in the ever-changing financial reporting landscape.