Understanding ASC 842
ASC 842 produces a substantial overhaul of the previous accounting treatment for leases, ASC 840, with the most significant change being that most leases will now be capitalized on the balance sheet. The goal of ASC 842 is to provide lenders and institutional investors with increased visibility into the leasing obligations of lessees.
Types of Classifications
Under the previous US GAAP regulation, leases were classified as either Operating Leases or Capital Leases. While Capital Leases were recorded on the company’s balance sheet, the Operating Leases were not. The new/current ASC 842 standard changes the types of classifications and the balance sheet treatment. With the new standards, both classifications of leases, Finance and Operating, will be on the balance sheet.
ASC 842 Transition Period
The transition period for most public companies began with the accounting period starting on or after January 1st, 2019. However, most private companies and some other entities have until 2020 to make the change.
Updated Disclosure Requirements
The new regulation requires extensive disclosures to increase transparency related to revenues and expenses regarding lease contracts. Lease entities are now required to identify whether a contract contains a lease when it is initiated. A contract is defined as a lease if it gives the lessee the right to “control” the use of property in exchange for consideration.
Control exists if the lessee has:
- The “right to obtain all of the economic benefits from use of an asset.”
- The “right to direct the use of that asset.”
This definition differs from the previous guideline, GAAP, that required the lessee to meet only the 1st requirement. Under the new standard, it’s up to the entity to determine whether it obtains the “right to direct the use” of the asset.
A comprehensive approach to compiling data is crucial to helping auditors understand how organizations have reached their lease determinations. Companies will need to consider details not typically thought of as leases, including outsourced warehousing, data management, or supply arrangements. These may be subject to the new guidance and therefore require capitalization.
There are still some fuzzy ASC 842 details that need to be ironed out. For example, an approach where the lessee models out its incremental borrowing rate for a standard property mortgage has been suggested.
Additionally, for companies with large numbers of leases, for example a national retailer with leased stores in several locations. An approach where leases/with similar characteristics get grouped into cohorts, and its value is calculated on a portfolio basis has been suggested.
However these fixes are addressed, ASC 842 promises to make 2019 a learning experience in leasing activity.
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