As finance professionals, we often hear the same accounting topics come up day after day. This recurring series will help bring you up to speed on accounting. Today’s topic: What is ASC 842 (lease accounting)?
First, what does ASC 842 stand for, and why is it important? ASC is short for Accounting Standards Codification which is US GAAP (Generally Accepted Accounting Principles. 842 is the code number within ASC. Accounting standards govern how companies record and report transactions. To that end, ASC 842 governs leases and replaced ASC 840.
The international version of accounting standards is IFRS (International Financial Reporting Standards). IFRS 16 is the international equivalent for leases.
Over the past several years, the US GAAP has been converging with the IFRS to provide a more consistent standard across countries and industries. As more companies expand beyond their borders, this is critical.
Lease Accounting Before the Change
Under ASC 840, companies distinguished between capital leases and operating leases. The balance sheet only included capital leases. Conversely, operating leases were a footnote on the financial statement. This excluded the impact of many leases from financial ratios and made it difficult to identify a company’s true debt load.
This loophole contributed to the demise of Enron. Because of this, a new standard to properly present leases on a balance sheet was necessary.
Lease Accounting After the Change
Following the change, leases are now classified as either a financial lease or an operating lease. This is a subtle but important change. Under ASC 842, if control of an asset is transferred in exchange for consideration, then it is a financial lease and must be recorded on the balance sheet. If the asset is allowed to be used but not controlled, then it is an operating lease.
How do we determine if a contract meets these criteria? And how do we know if control of an asset has been transferred? The new code gives us a two-part test to answer these questions.
Part 1: Indentified Asset
- A contract between the two parties must specifically mention and identify the asset.
- The asset is physically distinct.
- Lessor does not have the right to substitute the asset.
Part 2: Right to Control
- The lessee has the right to fully direct the use of the asset during the lease term.
- The lessee has the right to receive all the economic benefits of the asset during the lease term.
If the assets meet the conditions above, then it must be capitalized.
Impacts on Finance
To wrap up, let’s examine the impact on your day-to-day work as a finance professional.
- Forecasting – Capital leases will reduce operating expenses while increasing depreciation expenses. There may also be a slight timing adjustment if the monthly payment is not straight-lined. You will need to capture this change in geography in forecasting models.
- Balance Sheet – Assets (Capital Assets) and Liabilities (Leases) on the balance sheet will increase for any leases that were not previously capitalized.
- Analysis – The Financial Accounting Standards Board allowed companies to apply this change historically. This can cause noise in the results. As a finance professional, leadership may ask you to conduct additional analysis to Pro Forma results. This will help inform management of the impact and continue making the right decisions.
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